Showing posts with label Rebalancing. Show all posts
Showing posts with label Rebalancing. Show all posts

Friday, April 22, 2016

Time to Lighten Up on U.S. Stocks?

As those of you who follow my financial blogs know, I am a believer that the largest component of long-term investing results is one’s asset allocation. To maintain a proper allocation, one must periodically rebalance portfolios.

Since the beginning of the year, the S&P 500 has risen about 3.9%, which does not seem like a huge change. However, the year started off with a sizeable correction, so from its low this year, the S&P 500 is up over 14%.

And since it’s low in 2009, the S&P 500 is up over 200%, demonstrating why bailing on stocks when all seems gloomiest is exactly the wrong approach. And, I would argue, so is going all in on stocks as the markets continue to appear rosy. (That would be now.) Rebalancing forces one to sell off relative winners to buy relative losers.

If you haven’t rebalanced in a few months, it might be a good time to determine if your portfolio needs attention.

Only rarely do I change the allocation percentages of my various investment categories. Now, however, is one of those times. My sense is that U.S. stock markets are overpriced. As noted, The S&P 500 has already risen over 200% in the last seven years. That’s past. What matters is the future, and current price has everything to do with collective future expectations.

My expectations are a bit gloomy:

The bull market is already seven years old, but still propped up by expansive fiscal and monetary policy. The Fed still keeps interest rates artificially low. The U.S. Federal government stills pumps money into the economy. Its projected deficit for the year is $500 billion. Continually applied, these types of polices lead to bubbles.

Interest rates are much more likely to rise than decline (a negative to both stocks and bonds), unless a recession occurs.

Commodity prices have fallen substantially, temporarily boosting profits (consider airlines, for example). The five-year decline is likely to reverse.

The dollar has risen substantially over the last five years compared to major currencies (Euro and Yen by 30+%). This means U.S. based exports are more expensive and foreign earnings for U.S. companies have less value.

Much of the U.S. unemployment slack has been erased. This means corporations will have to pay more for talent they need. At the same time, much of the increased profit margin they have wrung out of labor costs by converting full-time positions into part-time and on call employees, outsourcing, and eliminating defined benefit pension plans and the like has already been fully reflected in earnings.

When (not if) the next recession occurs, the Fed will have fewer resources to counteract the liquidity crises that will surely occur because it has kept interest rates artificially low. Similarly, with the U.S. debt at record levels, Congress will be unlikely to approve appropriate economic relief measures.

Thus, the next recession will likely last longer and be deeper than would be the case if the U.S. economy were not starting from a position where expansionary measures are constantly in effect.
All of which says to me that U.S. stocks are riskier than usual in my portfolio. Recall that I am older and retired, which means I have fewer years to recover from any bear market and (worse) I do not have the ability to purchase more investments through savings from future earnings.

So my situation is different from yours, as may be my analysis of what to expect. But I figured I’d share my thinking and maybe learn something from everyone’s reactions.

~ Jim

Saturday, March 31, 2012

Is the Multi-year Bond Rally Over?

Back a month ago, I needed to rebalance my portfolio by selling some equities. I’ve dithered around reinvesting those proceeds in the fixed income portion of my portfolio, but when a CD matured this month, I simply had too much money sitting in a money market fund earning a walloping .03% a year. (That’s $30 per $100,000.)

Thinking about fixed income forced me to ask this question: is the multi-year bond rally over? My conclusion is that it is, but I have no clue how long rates will continue to stay at their current low levels. As I am writing this, 1-year treasuries have a yield of about .18%; 10-year treasuries yield 2.21%. For TIPs the real rates of return are -.11% for 10-year bonds and only .89% for 30-year TIPs.

Think about that for a second. If you buy 10-year TIPs you pretty much guarantee that after ten years you can buy less with the results of your investment than you can buy right now, and that’s before you pay taxes on your “gains.” Such a deal!

The Federal Reserve has committed to keeping short-term rates close to zero through 2014 in order to stimulate economic growth. They have also worked to flatten out the yield curve, which is part of the reason 30-year TIPs have real rates of return under 1%. (And 30-year mortgages are again under 4.00%)

Another reason for the current low interest rates is that with the instability of global economics, the US economy still looks like a good bet to those worried about their money. Despite the massive budget deficits the US runs, whenever there is a spike in economic uncertainty, money continues to plow into US treasuries.

Short-term we can have more uncertainty. The Fed can institute QE3 (quantitative easing round 3) and interest rates will again decline. Or Congress can do something stupid (alright, even more stupid than what they have been doing) and cause confidence in the dollar to drop. If I could prognosticate short-term bond moves, I’d be raking in 8 figures a year—and I’m not.

But looking at the long-term I think we must be very near to the end of the multi-year bond rally.

1. Very short-term rates cannot go much lower on a long-term basis than the virtual zero currently in effect. Yes, if there is a scare people may be willing to accept negative short-term nominal rates, but not for long.

2. Although we know bond buyers are willing to buy “safety” at the price of real value retention (witness the 10-year real TIP yield of -.11%), even as the Fed tries to flatten the yield curve, how much more real return are investors willing to give up for safety? And for how long a period—surely not for  30 years? This phenomenon cannot last forever.

3. US Inflation is running around 3% in an environment of 8% unemployment and the Fed holding down interest rates. If the Fed is successful at stimulating the economy, at some point wages will again start to rise and inflationary pressures will increase. Not only will bond yields will have to increase in order to maintain the same real rate of return, but the Fed may switch from worrying about unemployment to worrying about inflation and start to actively increase interest rates itself.

4. Money continues to move away from bonds, seeking higher returns. Corporate bonds have had a very strong run, with high-yield corporate bonds doing even better. As even these riskier investments are priced higher and higher, people will turn away from fixed-income securities and chase commodities (even more than they have.) Eventually the housing stock will rebalance and housing prices will start to rise, attracting new money.

5. Once the Fed either (a) no longer pumps money into the system because they think the employment market is healed or (b) starts to worry about inflation, their massive support of low interest rates will wane. At that point, there will be a very rapid rise in interest rates with the consequential large capital loss—largest in high-duration fixed income instruments.

I don’t know when this will happen, but I do think it will. And when it does, unless one can quickly liquidate one’s position, the capital losses will be massive. Unlike other fixed income bear markets where coupons offset much of the capital decline, now we have almost no coupon interest and so there is no cushion.

My personal conclusion is to keep in money markets only that amount I will need for expenses in the next year. Because of the Fed’s low rates, banks have little current need for investor funds so CD rates are pitiful. However, even those pitifully low rates are better than the equivalent duration treasuries, so CDs are preferable given that their principal is guaranteed (with limits) by the FDIC.

However, to even match inflation, I’ll need to put the rest of my bond allocation in short-term corporates. Doing so, I am taking on more risk, but I do not see corporate debt quality declining much in the next 24-months (and I’ll stay away from junk.) I’ll ladder a few securities, giving a bit of diversification in both company and duration. As bonds mature, I can decide how to redeploy those funds.

If I am wrong, I’ve given up a bit of yield to long-term bonds I could have purchased instead. If I’m right, I’ll save a lot in capital losses I have avoided. That sounds like a good trade-off to me.

~ Jim

Friday, February 17, 2012

Time to Rebalance?

Just a quick post to let everyone know I rebalanced my portfolio today. I was rushed, so technically, I only partially rebalanced—I sold equities. Since the beginning of the year, domestic and international equities have risen. At the same time interest rates have risen, meaning bond prices have fallen.

The net result for me was enough of an imbalance compared to my target allocation that I needed to rebalance. Over the weekend, I’ll address the bond side of my rebalancing and increase my bond holdings to get them back in line.

Your securities may have responded differently than mine, but perhaps it is time to take a gander at your allocation and see if you too should rebalance.

~ Jim

Thursday, December 29, 2011

Positive Returns in Volatile Markets

Last year I wrote a long post concerning the whys, wherefores and how tos surrounding rebalancing your portfolio. Calendar year 2011 isn’t yet over and anything could happen in the last two days of the year. However, unless the last two days are really bad, my net worth will increase in 2011.

As a reminder, I’m retired and have no income except from my investments. That means I was able to live off my investments and still have more at the end of the year. For this retiree, that is a successful investing year.

So in another twelve-months that most pundits are chalking up as one more “lost year,” after already “losing” the first decade of the 21st century, how did that happen?

I have two answers: diversification and rebalancing.


In another post I set forth my then asset allocation policy:

Bonds (44.0%)
    Short-term                     Balancing Item
    Medium-term                       4.0%
    Long-term                            0.0%
    Inflation-protected               15.5%
    Pension                               Actual%

Equities (50.0%)
    US Large-cap                       23.0%
    US Small-cap                       10.5%
    Europe                                  7.5%
    Pacific                                  3.5%
    Emerging Markets                  5.5%

Other Real Estate                      3.0%
Commodities                             3.0%

Total (100% )

The only changes I made to my asset allocation policy during the year were to reduce the medium-term bonds to 2.0% and decrease the Inflation-protected bonds allocation to 14% —both reflecting the lowering real rates of return. I kept the overall bond/stock/other allocations the same, temporarily moving the additional funds into money market accounts (where they are earning next to nothing).

Bonds increased in value through the year as the Federal Reserve continued downward pressure on interest rates, helped in large part by the instability in the rest of the world that made US treasuries look relatively rock-solid. The US stock market was mostly sideways or down for the year. Foreign securities were down a bunch, especially valued in US dollars. Commodities were up, down and now sideways. Real Estate Investment Trusts (REITs) added value during 2011.

Since I have more money in stocks than bonds and a higher proportion of international stocks than most, with a buy and hold strategy without rebalancing I would have generated a decrease in total asset value worse than the average bear.

Yet even after living expenses, I ended up with an increased net worth. Is this some new application of Wall Street math? No, it’s not. In 9 ¾ years of retirement and following my strategy of diversification and rebalancing, my net worth has increased about 45%. Diversification has helped even out my returns, as has periodic rebalancing.


The markets did not go uniformly up or down; they rollercoastered throughout the year. I rebalanced four times during 2011. I should have done it more often, but was distracted by other things. This is particularly true of my commodities position, where rebalancing would have earned me a better return. Live and learn.

Rebalancing is particularly useful in volatile markets. In some sense it forces you to sell when an asset is high and buy when it is lower. Looking at my actual purchases and sales of the Vanguard Index 500 Fund in 2011 shows how this worked to my advantage.

In January I sold shares at 117.59. In February the index increased and I needed to sell more shares to rebalance, which I did at 120.54. By September the index had declined to 111.37 and I needed to buy shares to rebalance. By December, I had to rebalance again, primarily because of the declines in international equities and sold most of the shares I bought in September at 116.48.

The gains are not huge, but they did earn about 5% on those funds that I would not have earned had I not rebalanced. Don’t confuse this with market timing where one attempts to pick the bottom to buy and the top to sell. Had I been prescient, I would have sold all my stock at the beginning of the year and put it into long-term bonds. Only my need to rebalance dictated the timing of the purchases and sales.

This strategy is about hitting lots of singles, about picking yourself from the dirt when the markets throw a bean ball and being prepared for the next pitch whatever it may be. If I were to fault myself for this year’s performance it is that I should have rebalanced a bit more often to reflect the increased volatility.

~ Jim

Wednesday, December 29, 2010

Four Steps to Rebalance Your Portfolio

If you implemented the ideas behind the last six posts, you have a fair idea about how to put together your personal portfolio policy. In previous posts we’ve talked about rebalancing, but never really addressed the question of how often and how best to accomplish it.

I suggest you look at your portfolio at least once a quarter to see if it is still aligned with your portfolio policy. If you enjoy getting down and dirty with numbers, then a monthly review will work even better. If you really, really hate this, but know you need to do it, then push the odious task out to six-month intervals—but recognize you are probably giving away a bit of your long-term performance.

Rebalancing is a four-step process:

Step 1: Determine the market value of all your investments. These days the market value of most of your investments should be available online. (And I know you can get online because you’re reading this.) Add up all the investments in each bucket of your portfolio policy.

Step 2: Compare the current allocation of your investments with your policy targets. I do this as dollar amounts; some people prefer to use percentages above or below their target. For example if large-cap domestic stocks are supposed to be 25% of your portfolio and that should be $100,000, and they actually are $110,000, then under my approach I would show the large-cap stocks as $10,000 too high. The percentage folks would show it as 110% of target (or 10% over target.)

Step 3: Identify any investments that are significantly higher or lower than your target. Rarely will you be exactly on target, and it takes time (and sometimes money) to rebalance your portfolio. Therefore you need to pick a threshold to rebalance. I choose a dollar threshold, so if the deviation is above that amount, I need to do something; below the limit means I can delay rebalancing that particular asset because the class is not significantly skewed.

Percentage devotees will pick some bracket and say that if the asset stays between (for example) 90% to 110% of target, there is no need to rebalance. Outside of the range, they need to do some buying and selling.

If you are in the investing stage of your life, you can often address your imbalances by deciding where to put new money. Sometimes you are constrained because much of your new investment is going into your employer’s 401(k) plan and you can change your contribution allocation a limited number of times a year.

In any event, the time to decide your rebalancing criteria is when you first set up your portfolio policy. If you wait until later, inertia will cause you to let the rebalancing slip (oh, it’s not too far off the procrastinator says) or fervor will cause you to rebalance more than you need (gosh, large-caps changed 1% today, I’d better fix that imbalance right now!)

Step 4: Decide the most effective way to rebalance. To the extent possible, I try to rebalance in my tax-deferred accounts because those sales do not generate taxes. If you’re a faithful reader of my blog, you know I use mutual funds for equities rather than individual securities [see Risk in Buying Individual Stocks 5/26/2010]. I mostly use index funds with no sales or purchase fees. (The rare exception is an emerging market fund with a low redemption fee.) With bonds, I use an online broker. The idea is to keep the transaction costs as low as possible. As a general rule, the higher the transaction costs, the less frequently you should rebalance because transaction costs diminish the benefits of rebalancing.

I maintain both a Rollover IRA and a Roth IRA. I hold some mutual funds in both accounts because many of them have frequent trading restrictions, meaning I can’t buy sold shares back in the same fund for two months. But if I sell (say) the S&P 500 Index in the Roth IRA and a month later I need to buy some back because of a big price swing, I can do so in my Rollover IRA if I have duplicate funds set up.

If you do want to frequently rebalance, and the repurchase restrictions are a problem, split your assets between two mutual fund companies. As long as you keep sufficient funds in each to qualify for the lowest fees the fund company offers, you can circumvent the repurchase restrictions. For example, you can sell Vanguard S&P 500 shares in December and purchase Fidelity S&P 500 shares in January if necessary.

If you only rebalance quarterly, this whole repurchasing issue won’t be a problem for you.

If you have to rebalance using taxable accounts, keep in mind the tax effects of any sales. Try to sell funds with capital losses or small capital gains; but if you can’t do that, it is better to pay some taxes (particularly at a maximum 15% rate) than to allow your portfolio to become significantly unbalanced.

If you use mutual funds with loads or sales costs, I suggest you consider no-load funds and make any new purchases in them. Over the long-term loads are a shackle on your flexibility and net returns—but that’s a different post.

Whatever route to rebalancing you choose, keep it simple so you can implement and stick with your plan. Better to rebalance only twice a year than commit to doing it monthly and then become sufficiently annoyed at the time and hassle that in frustration you stop rebalancing all together.

Following this approach you will usually end up selling winners and buying losers. For individual stocks that may not be a great plan, but when dealing with widely diversified mutual funds, I think of it as shopping in the bargain aisle and funding my shopping spree by selling off things that are becoming more and more expensive (as the price increases.) Unless you have the will of a mountain, you too will be tempted to hold on to a mutual fund “because it’s still going up.” Keep this in mind: if everyone believed those stocks must go up, they would have already increased in price.

Similarly, sometimes it feels like you are throwing good money after bad as some category falls into disfavor. Do it anyway. If you really feel squeamish, spread your purchase out over a few months rather than making it in one lump.

Financial professors have written a number of papers that show the most important determinant of long-term investment performance is the asset mix. I’d like to add that once you’ve made that all-important decision, the next best thing is rebalancing.

A couple years ago I had a financial advisor compare my personal investment returns to an approach using the same mutual funds utilizing rebalancing only once a year. He reported that in each of the five years my rebalancing policy had beaten the benchmarks. Will that always be the case? Undoubtedly not. A year will come when one asset class only goes up, another only drops—and I kept selling the former to fund the latter. In that kind of year I will not do as well as a strategy that does not rebalance, but none of us knows in advance when that is going to happen. Those who followed the tech stock boom up discovered it cratered much more quickly than it climbed. That’s usually the case for bubbles. If you haven’t been selling on the rise up, it will be too late when the crash comes.

An old Wall Street adage goes something like this: Bulls can make money; Bears can make money; Hogs get slaughtered! (Jim’s caveat is that if you can become the CEO the last statement no longer seems to hold.)

The calendar year is about to end. Isn’t this the traditional time for resolutions? How about reviewing (or creating) your investment portfolio allocation policy and rebalancing if things are out of whack.

~ Jim

Wednesday, December 15, 2010

Developing an Asset Allocation Model (Part I)

In my May 24, 2010 post I discussed rebalancing portfolios and how that assists in buying low and selling high. This week I rebalanced because stocks have been going up and bonds declined in value, so my portfolio was off kilter.

In addition to rebalancing this week, I also changed the target percentages for various asset classes. The percentage allocation to asset classes should be at the core of any investment program. One size does not fit all. I knew someone who got an A on an MBA finance exam when she answered a question about asset allocation by indicating she was completely risk averse. Preservation of principal was her only objective and therefore she would keep all of her money in cash, short-term treasuries and government insured bank accounts and money markets.

As long as the US government does not default, this investor will meet her objective of capital preservation. Since I don’t have sufficient assets to live off the current paltry interest return treasury bills, money market funds and the like pay, I need to take more risk in order to (hopefully) get greater return. My risk tolerance and yours may not be the same. We may have different objectives (mine is to not run out of money before I die) for our investments. If you are not sure of your objectives and risk tolerance, you can use any of a number of online tools to help define them. Use several since they have different implicit assumptions and their average advice may be more accurate than any one model.

I’ve periodically tweaked my asset allocation as I moved from employed to retired. Contrary to many popular wives tales, asset allocation need not change on account of age per se. The critical components are (1) whether you are accumulating, spending or in transition between the two, and (2) when you need to spend the money. Bull markets are never a problem; what happens to your assets in the inevitable down market cycles and how that affects your plans is the key issue.

When you are accumulating wealth, bear markets can be good things. You are a buyer regardless of market conditions. If you have $1,000 to invest, you will get twice as many shares if XYZ sells for $10 a share than you do when XYZ sells for $20 a share. If you have many years of accumulating to go, your future investments likely far outweigh the value of your current portfolio, and so market ups and downs are of little concern.

In the spending phase, you no longer have “excess” income to invest. Your portfolio accumulation is finished and you no longer benefit from buying at depressed levels after a market “correction.” Judicious rebalancing will help, but, for the most part, the only way to adjust to decreased investments is to decrease spending or dying earlier. Neither are pleasant alternatives. While a portfolio of Treasury bills will solve the problem of investment losses, they provide little real return, which leads us back to the problem of insufficient funds to live solely on Treasury bill income. Most of us must take some risk in our portfolio.

I define the transition phase as the period before retirement in which the size of accumulated investments has become large enough that future annual additions can no longer make up for large market declines. The earlier you start to save, the quicker the transition period comes.

Next up: Asset Classes to Consider in Your Portfolio

~ Jim

Monday, May 31, 2010

Ignoring the Daily Market Report

You’ve heard the same dribble I have on the daily market report. The announcer breathlessly says something like, “The Dow surged higher today on news that same store sales increased one-tenth of one percent in the first quarter.”

Three weeks later the compiler of the statistic posts a correction and it turns out the minimal increase was in fact a decrease of one percent. No mention is made in the commentator’s daily report on the day of the change because the markets rose that day and the poor guy needs to find some reason “there were more buyers than sellers.”

Let’s tackle that one first. For every share someone wanted to buy, someone else wanted to sell. If at a given price more people would like to buy than sell, the price moves up until either potential buyers drop out (because it is now too expensive) or more sellers show up because of the higher price. This leads to the classic supply/demand curve:
As demand for the shares increases from Q1 to Q2, the price increases from P1 to P2, shifting the demand curve upwards from D1 to D2. Prices could also increase when supply decreases while demand remains constant. When stock prices fall it is either because demand decreased or supply increased.

The other thing to keep in mind is that 50% to 70% of the trading in stocks today is between two computers. Computers make decisions based on complicated algorithms designed by their masters. While it is possible the one-tenth of one percent same store sales increase is a component in an algorithm here or there, my guess is it’s not a big driver and certainly not the only one.

Assume the government releases the statistic at 9:00 am. By the time the markets open the algorithms have already reflected the new statistic, meaning the computer already knows whether it wants to buy or sell at the opening bell and at what price. What’s happening the rest of the day? At best the release of the statistic is like a stone tossed into a pond that generates a few ripples. After that, clear water. It certainly is not the driver of all purchases and sales.

At the end of the day the markets went up or went down. Unless the change has caused your portfolio to become unbalanced, do yourself a favor and ignore the market pundit.

~ Jim

Monday, May 24, 2010

Buy Low, Sell High

Well sure, everyone wants to buy low and sell high. The question is how to know what’s high and what’s low. If you are expecting an answer to that question, you will be disappointed, but I do have a technique that has worked well for me over the years.

I rebalance my portfolio whenever it needs it. Each month I develop a balance sheet and I check to see how far out of whack my actual investment allocation is relative to my “ideal.” If there is a large enough difference, I sell whatever I have too much of and buy whatever I need more of.

How do imbalances occur? Either an asset class has risen more than others (not a bad problem to have), or has fallen more than others. Sometimes one asset class rises while another falls. However it happens, when a significant imbalance occurs, I rebalance by selling the one that has made relatively more money (which is selling high, more or less) and buying the laggard (buying low.)

I try to keep as much of my balancing in my tax-deferred accounts to avoid immediate capital gains taxes. I also hold down fees and expenses by utilizing mutual funds (mostly index funds) rather than individual stocks. On Wednesday I’ll explain my preference for mutual funds over individual stocks.

~ Jim