Key Takeaways
With the remarkable growth of equities in recent years, your portfolio may be more heavily tilted to stocks (and volatility) than you realize.
Just like dental checkups and oil changes, regular rebalancing is part of maintaining a healthy, well-diversified portfolio.
Before rushing to rebalance, see if your overall objective, your tax situation or your risk tolerance has changed.
Rebalancing your portfolio is a prudent element of every investment plan. How you approach rebalancing and what you consider in your decision-making process are keys to your financial success. I bring up rebalancing because stocks (as measured by the S&P 500) have risen by more than 26% a year on average for the past three years. After such remarkable growth, there’s a good chance stocks now account for a much higher percentage of your portfolio than you might realize. As a result, your level of risk is higher than you may be comfortable with. There’s no need to panic, but you want to be smart about getting your portfolio back into the balance that’s right for you at your current stage of life. Take a moment to review the chart below showing rolling three-year returns for the S&P 500. As you can see, the pattern has been anything but consistent over the past 40 to 50 years. While this choppy volatility makes some investors nervous, it provides good rebalancing opportunities. Just like dental checkups and regular oil changes for your car, rebalancing is part of maintaining a healthy, well-diversified portfolio. By owning a mix of assets that don’t move in lockstep during varied market conditions, you can smooth out your overall investor experience and hopefully sleep better at night. That’s where rebalancing comes in.
For instance, if your ideal allocation is 60% stocks and 40% bonds at all times, you will have to do some rebalancing to get back to that ratio if you haven’t done so in recent years. That’s because the strong run-up in stocks over the past three years (see above) has likely moved you to 70% stocks/30% bonds, perhaps even 75/25. The additional exposure to stock is great for returns, but not so great if you rely on your assets to meet your cash flow needs. The additional exposure to stocks could also jeopardize your withdrawal ability. Here’s why. When you need to start drawing from your portfolio, you must sell assets to free up cash. If you allow the allocation to drift too far from your investment plan and then the market suddenly drops, you may have to sell assets that have suddenly dropped in value to meet your needs and circumstances today. That is why it is important to have a cash flow plan in addition to your investment plan. You always want to know where your cash will come from under any market scenario.
Time to rebalance?
Before rushing to rebalance, let’s see if these three key criteria have changed since you set up your investment plan: (a) Your overall objective, (b) Your taxes, and (c) Your risk tolerance. Let’s review these three important factors one at a time:
1. Taxes. Are you still working full-time and in a high tax bracket? Or are you retired with a lower income that allows you to realize gains at the 0% or 15% bracket? If you are only a few years from retirement, you may choose to delay liquidating and paying potentially the 20% bracket +3.8% for Net Investment Income Tax (NNIT) and any state income taxes. New Jersey has a graded schedule and bumps to 8.97% at $500,000. Also, if your income is low enough, you could avoid capital gains entirely.
2. Overall objective. Do you have many years before you must rely on your invested assets for income, or do you now depend on your portfolio for your living expenses? If you have plenty of time, then you may want to allow your portfolio to drift a bit. Put any additional savings you have available into the right asset buckets to get you back to your preferred allocation. But, if you are only a few years from retirement, then you may want to shift to more conservative assets such as short to intermediate term bonds. We are aware that these investments may struggle to maintain purchasing power. That is why we are not recommending that you secure more than is necessary to give you peace of mind and the comfort to stop earning a paycheck. 3. Risk tolerance. Do you worry every time the markets go down? Do you have difficulty sleeping at night when thinking about your investments? If so, your risk tolerance will not permit you to stomach much volatility in the market, but then the tradeoff is taxes. Please do not allow the fact that Uncle Sam is your partner to deter you from getting sleep at night. For more about understanding your risk tolerance, see my colleague Dan Satz’s post Do You Have Enough Risk in Your Portfolio?
Your answers to the three considerations above should drive your decision about rebalancing.
How to rebalance If you and your advisor have determined that it’s time to rebalance, first look at your IRA or 401(k) qualified accounts for holdings to sell. There are no tax consequences for selling assets that have appreciated within an IRA. You don’t have to sell your holdings all at once, by the way. You can do so on a fixed interval, such as quarterly or annually. But you may be able to increase your total return by using a “bandwidth strategy.” Consider this example of bandwidth: If your target allocation for real estate is 10%, but it has recently dwindled to 8% of your portfolio, then you would buy more real estate until your allocation is back to 10%. On the flip side, if real estate has a run-up and now accounts for 12% of your portfolio, you would sell more of your real estate holdings until they account for just 10% of your overall portfolio. For more about rebalancing, see this insightful article in The Journal of Financial Planning.
The above recommendations are based on rigorous research and empirical data. But there’s another important factor here that can derail even the soundest of financial plans – what’s between your ears.
Resisting your emotions
Study after study shows that humans are notoriously bad investment decisionmakers. When everything is going well, they want to add money to the equity side of the portfolio. When things are not going well, they want to hold cash or sell positions. This is the exact opposite of the behavior a smart investor should follow. Most know the adage, buy low/sell high, but most investors do the reverse (and later live to regret it).
Conclusion
Investing is more about planning your personal needs than it is about tracking the markets. If you have a solid cash flow plan and investment plan, then you can make smart decisions based on those plans. You don’t have to lose sleep trying to guess whether the market will go up or go down. If you can plan for your time horizon, needs and circumstances while taking into consideration your comfort with risk, you will have great outcomes.
As economist Benjamin Ola Akande liked to say: "Hope is not a strategy.”
If you or someone close to you has concerns about your portfolio or retirement readiness contact us any time to discuss in more detail. We’re happy to help.
ROBERT B. DUNN, CFP® is the President and Managing Partner of Novi Wealth
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