Are You Rebalancing Your Portfolio?

Genia Turanova's picture

Wednesday, July 12, 2017 - 12:00am

by Genia Turanova

Baby steps. 

This is how most investors start, with a smallish sum of money and only a few positions. 

Over time, these holdings appreciate, and investors put additional money to work. The portfolio grows, and with that, so does its complexity. Sooner or later, many investors begin to feel the need to get organized. And for that, they need to understand the basic rules of portfolio building. 

Of course, as a finance professional, I think this should be filed under the category "the sooner, the better." Investing is a serious affair, and it's good to follow the basics from the beginning. But it's never too late to start. 

The first decision any investor should make is all about asset allocation. The exact portfolio allocation for stocks, bonds and cash should largely depend on an investor's own time horizon and risk tolerance. General guidelines can be applied , however, nobody knows your situation better than you do, and the process of determining where you want your money to go is much more personal than any newsletter allows. 


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Still, income investors should take into account the following considerations:

1. Interest rates are going up. Since December 2015, the U.S. Federal Reserve has now raised interest rates four times. And just last week, the European Central Bank talked about slowing down, stopping or even reversing some of the elements of its quantitative easing program. Other central banks have also markedly changed their tune lately, with talks about easing all but stopped. Interest rates and bond prices move in opposite directions, so when interest rates start moving up (and they eventually will), bond prices will decline. 
 
2. With interest rates rising, even the prospects for equities have become less bright. Many factors remain positive; we're seeing strong employment numbers, inflation is still largely absent, and our economy is still growing. On top of this, by most historical measures, interest rates in the United States are still quite low, so there is still no substitute for an equity portion in a portfolio for income investors. But some caution going forward would be justified. 

3. This brings us to the question of cash. In fact, cash has a very important role in any portfolio: Because it's essentially a risk-free investment, it can help investors weather bouts of volatility while also serving as a source of funds for when new opportunities arise. Plus, just as with any asset class, by changing the amount dedicated to cash, investors could better accommodate their risk tolerance and/or different investment horizons. 

4. The single most important tool available to any investor is diversification. While almost by definition, an income-oriented portfolio isn't as diversified as a portfolio with a different goal could be, this does not mean income investors should give up on diversification altogether. In fact, allocating your assets among stocks, bonds and cash is just a first step in reaching that goal. 

Having different stocks and funds from all walks of life, sectors and industries -- well, most of them, as long as they pay a decent dividend -- reduces an investor's exposure should a problem arise in an individual company or even an entire sector. 

International stocks shouldn't be overlooked either. If certain conditions hold, Europe, with its improving growth prospects, is expected to offer better values than the United States. Investors at some point might want to consider beefing up their exposure to the region. 

All of this also means that investors should be flexible. Sometimes, the market will dictate the need to change allocation. And when an investor's circumstances change -- for instance, as they get older and closer to their goals -- they will also need to adjust their allocation.

But once you have your ideal allocation, you might want to employ certain elements of another strategy -- rebalancing

Why Rebalancing Matters
In its pure form, rebalancing calls for bringing a portfolio back to its original asset allocation mix. 

Think about it: Over time, some assets in your portfolio will appreciate faster than others, and some will even decline. Rebalancing would bring your portfolio allocation back to its original alignment.

Let's take a look at a hypothetical example. 

A year ago, an investor opens an investing account. At that time, she decided the ideal allocation for her portfolio was 50% U.S. equities and 50% bonds (equally divided between munis and junk bonds). Given how these assets performed over the past year, the allocation today has shifted from that ideal designation: U.S. equities now occupy 54% of the portfolio, and bonds take up much less space, largely due to the loss on munis. 

If, at this time, our hypothetical investor decides to rebalance, she would need to sell some of the equities and buy more of the munis. This would return the portfolio to her original ideal allocation -- 50% U.S. equities, 50% bonds (equally split between munis and junk bonds) -- which would again carry the original level of risk our investor is comfortable with. 

Even though there is no real urge to act, this would mean that our investor would sell the winner and buy the loser. On the other hand, she would "sell high" and "buy low." While there's no guarantee this will lead to a higher return in the future, the result of returning to the original, well-thought-out allocation is disciplined profit-taking and risk-reduction. 

In the long run, getting some gains from assets that have performed well while buying securities that have underperformed can actually help with the overall performance. Some studies indicate this is indeed what happens. 
Rebalancing works. 

Time and time again, we hear pundits advising us to "buy low, sell high." Easier said than done, right?

Well, as I started to get at with our "hypothetical investor" example above, this is what rebalancing is in its deepest sense. 

Investors who adhere to rebalancing strategies periodically sell some of their best performers and buy more of stocks or sectors that have been lagging. Buy low, sell high indeed -- and no sarcastic connotation needed. 

Plus, rebalancing can result in a higher portfolio yield. Just look at the popular Dogs of the Dow strategy.

At the beginning of the year, investors following this strategy invest in the 10 highest-yielding Dow stocks, with a goal of outperforming the market. On the last trading day of the year, those investors sell their Dow holdings and then buy the new highest-yielding Dow stocks.

The logic behind the Dogs of the Dow strategy is two-fold: First, it relies on the idea that the Dow Jones Industrial Average represents inherently sound stocks that will (eventually) come back. Second, those stocks' higher-than-average dividend yields mean they are oversold.

Essentially, this strategy is an implicit bet that the underperforming stocks with the highest yields are likely to be at or near the bottom of their business cycle, and that their currently depressed prices (and abnormally high dividend yields) won't last. The resulting portfolio has a higher yield than the Dow.

Knowing this, it's quite surprising that some investors still need to be convinced that there are indeed benefits to this strategy. Perhaps because it's easy to understand but not too easy to execute? 

We place a high premium on rebalancing in my premium newsletter, The Daily Paycheck. Our goal is to create an income-producing portfolio that offers a range of options for investors -- no matter their individual situation.

We couldn't do that without diversification and rebalancing. And for rebalancing to work, as with all investing matters, it requires discipline. 

It's one of the reasons we've been able to generate $117,847 in income at last count, while our model portfolio has grown from an initial $200,000 in value to nearly $350,000 today. All while remaining less volatile than the S&P.

If you'd like to join my Daily Paycheck readers and I in our quest for income, then I encourage you to follow this link. You'll learn all about our strategy and how you can put it to work for you today.

Genia Turanova does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.