Why Diversify and Rebalance?

We recommend that one should strive to build a diversified portfolio of various assets whose returns don’t all tend to move in the same direction.  If one asset class “zigs” while others “zag,” you can potentially offset some of the impact of the declining asset.  This often conjures up the old saying “don’t put all your eggs in one basket.”

Let’s go a bit deeper.  In our view it is also important to stay diversified within each major asset class.  You can diversify equity investments by investing in stocks of companies that are of different sizes (large, mid, small) and across various industries (sectors) and vary by geographic location (US, international developed nations, emerging market nations).  Since markets, sectors and regions will not necessarily thrive at the same time, you can help reduce your portfolio’s risk and volatility by investing across different parts of the stock market.

Similarly, you can diversify the bond portion of your investments by including bonds with different maturities and credit qualities, as well as by buying government and corporate bonds and bonds from different regions.

Did you know that rebalancing can help maintain appropriate risk levels over time?

It is difficult not to be emotionally affected as you observe certain investments in your portfolio perform well or decline in value.  When markets are doing well, people tend to want to buy more of that investment.  This is often referred to as “chasing returns” or “investing by looking in the rear-view mirror.”  Likewise, many people want to sell an investment during times of declining market value.

Instead of buying when markets are high or selling when markets are low, we recommend that one should stay disciplined about maintaining the asset allocation that targets the level of risk that is appropriate for one’s goals, time horizon and tolerance for volatility.  In order to maintain the appropriate allocation, you need to periodically rebalance by selling assets that may have appreciated above your target and buying assets that are below your target level.  Note, this often means that you sell assets that have done well and buy more of an asset class that has declined.  “Selling high” and “buying low” can seem counterintuitive if your emotions tell you to do the opposite.

For example, some clients had a particularly difficult time staying committed to their asset allocation during the market downturn of 2008 and 2009.  We had to talk a few clients “off the ledge” to not sell out of equities and move to cash.  For those clients who stayed the course and remained fully invested during this difficult period, this meant they were buying more equity investments when U.S. equity markets were at historic lows.  Adhering to such a strategy with a diversified 60/40 portfolio made up of the S&P 500 and Barclays Aggregate Bond Index, one would have recovered fully from the S&P 500 Index’s low point in a bit under two years (whereas the S&P 500 Index on its own took more than three years to return to its November 2007 level).

For many who sold low and moved to cash, they struggled with deciding when was the “right” time to get back into the market, and they may still be playing catch-up.

If you don’t rebalance, a prosperous stock market and a resultant higher allocation to stocks could expose your portfolio to more risk and volatility than is appropriate for you.  Remember that stocks typically are more volatile than bonds, and your portfolio would be exposed to an increased likelihood of larger ups and downs.  Rebalancing allows you to realign your investment mix to the appropriate allocation and risk level for your goals.  Emotions and investing do not mix well.

How should you determine the appropriate allocation for you?

There is no right or wrong answer to this question, because each individual’s circumstances are unique.  The mix of stocks and bonds is typically based on your goals and timeframe and your appetite for risk.  If you have a longer period of time to invest until your targeted goal (retirement for example), or if you have a greater tolerance for ups and downs in your portfolio, then you may be more comfortable with a greater allocation to stocks.  Conversely, if your goal is only a few months or years away, or if your stomach does flip flops every time the stock market drops, then you probably will be more comfortable with a lower allocation to stocks.  As previously stated, stocks tend to be more volatile than bonds, but they tend to have a higher appreciation potential, and longer timeframes can help smooth out short- term volatility.

Remember that asset allocation is not a “set it and forget it” activity.  Once you determine your target investment mix, you need to review your portfolio periodically and rebalance to maintain a risk level that is appropriate for you.  Consult with a financial advisor or investment professional for help with any of these steps and consider the associated tax ramifications of selling investments with embedded capital gains or losses.