The nuances of rebalancing

iStock_000019901243SmallI recently received a question from a client of mine about an article that referenced rebalancing a portfolio at the same time each year. In theory, an annual rebalance is not a bad way to go. However, there’s quite a bit more to how we manage the rebalancing process than that.

For Merriman clients, we:

  • Avoid unnecessary transaction costs by using cash inflows and outflows as a tool to rebalance a portfolio back to its target allocation. Cash inflows are used to buy underweight asset classes and cash outflows are used to sell overweight asset classes.
  • Allow assets that are performing well to continue to perform – a documented trend called momentum – by placing tolerance bands around our allocations. This also helps avoid excessive rebalancing transaction costs.
  • Favor rebalancing tax-deferred accounts in December to coincide with mutual fund distributions and Required Minimum Distributions (RMDs), again reducing transaction costs.
  • Help defer taxes by rebalancing taxable accounts in January, when appropriate.

Market performance can also have an impact on the need for rebalancing. If returns are flat for a few years, there is less need for rebalancing. In volatile times, more.

In addition there will be one-off cases such as:

  • Tax loss harvesting. If there is a significant downturn in the markets (think 2008), we can use that as an opportunity to harvest losses to be used against future gains. We did this for our clients in 2008 and it is paying dividends today.
  • Introduction or deletion of an asset class can also provide an opportunity to rebalance your portfolio.

Rebalancing your portfolio is an integral step in maintaining a well-balanced portfolio and reducing its risk. But to do it once a year at the same time every year may not be the best solution for you. Depending on your situation, a more customized rebalancing approach may save you significant money in transaction costs and taxes in the long run. As always, check with your advisor to find out what’s right for you.

An alternative to the financial news treadmill

Every day, financial news sites and channels provide a steady stream of conflicting opinions and predictions that often leave investors feeling confused, frustrated, and paralyzed. Don’t believe me? Please allow me to elaborate.

In addition to reading a wide range of investing and personal finance pieces each day, in the evening I often browse a site called RealClearMarkets.com to make sure I take a look at some of the interesting and/or important articles I might have missed during the day. RealClearMarkets.com is basically a consolidator of articles from a number of other sources. You might want to take a look at it just so you can see what I mean.

When I review the list of approximately 50 headlines, I always find it interesting to see how many compelling yet contradictory articles and videos are in one spot, one right after another. It’s common to see one claiming one view, with another of the exact opposite view right below it. China is imploding/China is still a sleeping giant, Gold is headed much lower/Gold will touch new highs by the end of the year, The stock market is about to re-visit the lows of 2008/The stock market is pausing before reaching new highs by year end, Stick with large cap U.S. stocks/America’s best days are behind us and one should look abroad for better investing opportunities, A bond catastrophe is upon us/Don’t believe the bond bust hype, Inflation is about to run rampant/Deflation is the new worry, Emerging market stocks and bonds are to be avoided at all costs/The long term secular growth story of the emerging markets is still very much intact. Good grief! What’s an investor to do?

We’ll continue to see these contradictions, but one does not need to feel paralyzed by them or compelled to decide which one is the better path to follow. The truth is that they all have elements of truth and quite often are written by some very bright people. This month marks my 27th year in this business, and I have seen investors get caught up wrestling with these contradictions in each and every one of those years. Please let me offer an alternative.

Rather than struggling to decide if this is the right or wrong time to hold stocks or bonds in your portfolio, or which types of each to hold, how about always holding a portion in stocks and a portion in bonds, along with an adequate cash reserve for emergencies or opportunities that may arise? Of the portion devoted to stocks, hold U.S. and foreign (including emerging markets), small  and large cap, growth and value, and also some REITs (both foreign and domestic). Of the portion destined for bonds, hold those of the highest credit quality (which tend to hold up relatively well when the stock market severely declines), and those with short- to intermediate-term maturities (which have lower interest rate risk in a rising rate environment).

With regard to cash reserves, the rule of thumb in the financial planning community is to maintain enough to cover 6 to 12 months of living expenses, depending on your situation, but often these targets tend to be on the low side. My experience has been that during periods of severe market or personal financial stress, nothing provides peace of mind like cash. Nobody ever complains about having too much cash on hand during these times. And when opportunity knocks, it’s nice to have plenty of cash on hand to take full advantage. Even when yields are as low as they are now, cash is king. The purpose of your investment portfolio is to deliver returns in excess of inflation over time. Cash is for liquidity, flexibility, and peace of mind.

The appropriate mix of these various asset classes, of course, depends on your individual circumstances and objectives. A big part of my job as an investment advisor is to help clients establish and maintain this mix in the face of unrelenting alarmist news headlines.

If all this advice sounds like nothing more than common sense and things we’ve all heard before, you’re right. But interestingly enough, many people tend to get caught up in all the predictions and hype out there, and they tend to ignore or forget these time-tested principles. As Paul Merriman once said, “There is a Grand Canyon of difference between what people know they should do and what they do.”

If you are tired of feeling confused, paralyzed, and frustrated and would like to jump off the financial news treadmill, I invite you to contact us. If you are not quite there yet, I wish you luck and a quiet mind as you continue down your path. We’ll be here when you need us.

Risk mitigation

The return-centric environment in which we live too often gives little credence to an equally important measure – risk. Professionals and individual investors alike can often quote the return of a given stock or index, followed by silence when asked to recite its relative measure of risk. The financial crisis shouted to us the importance of understanding and controlling risk. If you did not hear the call – and hopefully you did before the fall – it’s not too late to answer it.

Two quantifiable means of controlling risk are diversification and asset allocation.

Proper diversification stretches well beyond your region and your country of residence. It has little to do with individual stock positions or individual sectors. It consists of all types of stocks – large, small, value, growth, etc., which are located all over the world. Global diversification is the goal.

Diversification is equally important for bond allocations. A bond portfolio consisting of high-yield bonds differs from one invested in U.S. treasury bonds. Obtaining an adequate amount of diversification on both sides of your portfolio is essential in controlling your risk.

Asset allocation speaks to the percentage of stocks and the percentage of bonds in your portfolio. While the specific mix has many variables, age and retirement goals are often large factors. Each investor’s situation is unique and there is no “one size fits all” solution. A good place to start is by answering the following questions:

  • At what age do I begin adding bonds? 40? 45?
  • How often do I add bonds and how much do I add?
  • What is an appropriate allocation once I am retired?

If you are struggling to answer these questions, it may be time to seek professional guidance. The answers are essential to your long-term investment success.

Investor discipline is a less tangible but equally important component of risk mitigation.

As stocks outpace bonds, a portfolio’s risk increases. At some point, there will be a need to sell the stocks to buy bonds and maintain the target allocation. In essence, this follows the golden rule of investing – that is to sell high and buy low. The same logic holds within each asset class of the portfolio, such as when international stocks outpace domestic stocks or small cap stocks outpace large cap stocks.

I can almost guarantee that when the time comes, rebalancing will not feel like the natural thing to do. Why, for example, would you want to buy into an underperforming asset class? Despite our rational brain, loading up on the winners will feel like the right thing to do at that moment. There are two questions you must ask yourself:

  • Do I have the discipline to rebalance my portfolio?
  • What mechanical process will I use to rebalance?

Your long-term investment success hinges on your answers to these questions. If you do not know how to answer them, seek guidance.

Investing is about risk and return. Understanding how much risk you can afford to take and how much risk you’re willing to take is the key. Quantitatively, two ways in which we control risk for clients is through diversification and asset allocation. Keeping clients disciplined in their goals and executing on a well thought out rebalancing process is another, less tangible means of controlling risk.

As Warren Buffet famously said, “It’s only when the tide goes out that you learn who’s been swimming naked.”