It's almost exactly two years since global financial markets traded at all-time high levels. These last two years have seen markets drop by 60 percent, and then stage a furious rally to recoup some of the losses. Commodity prices surged, then fell rapidly and are back surging again. Economic growth went from stable to non-existent. In most places in the world (with the exception of Israel) you can still hear the pop of the real estate bubble. This financial roller coaster has left many investors scratching their heads as what to do next.
Investors should take the time to make sure that their portfolios are well positioned for current conditions. One of the most overlooked aspects in long-term investing is the need to rebalance a portfolio. Rebalancing is important for two main reasons. First of all, it keeps your portfolio in tune with your long-term goals and second, it keeps your asset allocation in line with your risk level.
Creating your asset allocation, or the mix of stocks, bonds and cash in your portfolio, is the single most important task that an investor has to face. Many studies, including one done by Ibbotson Associates, have shown that the proportion of stocks, bonds and cash held in a portfolio has a greater effect on its returns and volatility than the individual investments that are chosen.
That is why after assessing one's investment goals, it's of the utmost importance to create an allocation that can help you achieve the aforementioned goals.
Let's examine the following example: an allocation of 60% stocks and 40% bonds within a $100,000 portfolio. In this example, we may assume that over the course of the next few years, the stock market drops and bonds move up.
Assuming all gains and dividends are reinvested and no money was deposited or withdrawn, the stock portion of the portfolio would be worth less than the initial $60,000, while the bond holdings would be worth more than the $40,000 invested.
We see from here that changes in the market can impact the makeup of a portfolio. Here, instead of being a 60% stock and 40% bond allocation, the portfolio becomes an allocation of 50% stocks and 50% bonds.
If bond returns outpace stocks returns by enough of a margin, the portfolio may become more bond-heavy, or conservative. Conversely, in time periods when stock returns are much higher, you can end up with portfolios more heavily weighted toward stocks than when they started out. The result for investors can be a portfolio that is completely different than they want, and unaligned with their risk profile.
BUY LOW/SELL HIGH
We are all familiar with the famous investing goal of buying low and selling high. Unfortunately most investors tend to buy high and sell low. A benefit of rebalancing is that it forces the investor to sell high and buy low. This is something that investor's say they want to do, but they rarely have the discipline to do. If stocks have a bad year and bonds move up, then the stock portion of a portfolio drops in value, while the bond part increases. To put a portfolio back in line, it is worthwhile buying some beaten down stocks and selling some bonds. This fulfills the principle of buying low and selling high. Just look back at these past two years. When the market was constantly rising, greed took over and investors bought more and more stocks. Eight months ago when it looked like financial Armageddon was upon us, investors became consumed by fear and they instinctively sold anything that smelled of a stock. Had investors stuck to the principals of rebalancing, much of the financial turmoil could have been avoided.
With the current market volatility, it is worthwhile speaking with your financial adviser to make sure that your portfolio is well designed with your financial goals in mind.
i>Aaron Katsman is a licensed financial adviser both in the United States and Israel, and helps people who open investment accounts in the US.