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Stocks, bonds, and your portfolio: A (re)balancing act

November 25, 2013

It's been a good year for the stock market, with both the S&P 500 Index and the Dow Jones Industrial Average up about 30% as of mid-November. Predictably, cash flows into U.S. equity mutual funds throughout the industry have been robust, according to data from independent market observers like Morningstar and MSCI.

As with any market rally, this year's upswing has made many investors quite happy. How long it will continue, of course, is anyone's guess, and some analysts are already talking about the possibility of a correction.

What's in your portfolio … and why?

A lot of investors—including some who consider themselves pretty good at managing their assets—have a tough time explaining what they own and why.

Fortunately, there's no reason to be caught off guard when someone asks about your portfolio and the strategy behind it. Here's a simple guide to answering those questions.

Read the article »

Whatever the immediate future holds in store for Wall Street, this is a good opportunity to take a close look at your portfolio and assess how recent market performance has affected your asset allocation—that is, your overall mix of stocks, bonds, and short-term reserves such as money market funds. You may find that the rally has caused your stock allocation to swell beyond a level you're comfortable with, and that it's time to take "corrective" action of your own.

Taking the pulse of the market

Fran Kinniry"We are now seeing—for the first time since the onset of the global financial crisis—significant positive cash flows into stock funds and negative flows out of bond funds," said Fran Kinniry of Vanguard Investment Strategy Group. "Investors tend to flee stocks during downturns and become enamored with them again after upswings."

For bonds, as Mr. Kinniry noted, the picture has been rather different. While plenty of cash flowed into the fixed income sector in recent years when bond returns were stronger, a sharp drop in bond prices several months ago was followed by significant declines in new investment to bond funds.

"Buying stocks now may actually run counter to what many prudent investors should be doing," Mr. Kinniry said. "I would start with the suggestion that you should review your asset allocation. If you have an equity-heavy portfolio, you will most likely need to direct new cash flows to bond mutual funds, or sell stock mutual funds to maintain your target asset allocation."

Returns vs. cash flow

So, if your portfolio has suddenly become overweighted with stocks, you may want to think about rebalancing. But before making any major investment moves, ask yourself three questions:

  1. What are my financial goals?
  2. How much time do I have until I need the money I'm investing?
  3. How comfortable am I with the inherent risks of each major asset class—stocks, bonds, and cash?

Let's start by focusing on your current asset allocation and whether it's time to rebalance.

Vanguard.com and our mobile apps make it easy to put your investments under a microscope. When you log on, we'll show you how your portfolio is allocated between stocks, bonds, and short-term reserves. If your stock allocation is bigger than you expected—if, say, it's more than 5% above your target—you may want to make some adjustments.

The easiest method to rebalance is to change the way you invest new money going forward—through your future IRA contributions or 401(k) payroll deductions, for example. Or you could do it faster by selling stock shares and buying bonds. But be aware that such a transaction could have tax implications down the road.

The benefits of rebalancing

Vanguard believes that rebalancing should be part of your regular portfolio maintenance schedule. Research by our analysts, along with independent academic studies, shows that the overall stock/bond/cash mix of assets in your portfolio is likely to have a far greater impact on your long-term returns than which individual securities you buy.

In practice, that means deciding on a blend of stocks, bonds, and cash that's appropriate for your goals, time frame, and tolerance for risk ... and rebalancing when necessary to maintain the right mix over time. It means focusing on the big picture, not on yesterday's winners or tomorrow's potential losers.

What it doesn't mean is loading up on stocks because equities have been on a tear or selling bonds because they look like they might be heading for a rough patch.

Colleen Jaconetti"We believe the primary goal of a rebalancing strategy is to minimize an investor's risk exposure relative to a target asset allocation, rather than to maximize returns," said Colleen Jaconetti of Vanguard Investment Strategy Group.

"Over time, as a portfolio's investments produce different returns, the portfolio will likely drift from its target asset allocation, acquiring risk-and-return characteristics that may be inconsistent with an investor's goals and preferences. Therefore, to recapture the portfolio's original risk-and-return characteristics, the portfolio should be rebalanced.

"We don't know whether rebalancing will increase the returns on the portfolio," Ms. Jaconetti said. "That depends on market performance. But we do know it can help control the risk exposure of the portfolio."

Bonds: the unloved asset class of the moment

In a recent webcast on the state of the bond market, Ken Volpert of Vanguard's Fixed Income Group highlighted the tendency of less disciplined investors to lighten their allocation to bonds based on short-term performance or on speculation about current events such as changes in Federal Reserve policy.

Indeed, the outlook for bond returns is modest at the moment. Vanguard projects annualized returns for the broad taxable U.S. bond market in the 2.5%–3% range over the next decade. That's slightly below the historical return of 5.5%, although inflation is also expected to remain below historical averages, so real expected returns would not be meaningfully different. (Source: Vanguard, using the Barclays U.S. Aggregate Bond Index as a benchmark.)

Even so, investors who choose this moment to sell bonds and sit on the sidelines may come to regret that decision. After all, Vanguard believes bonds and bond funds can still play a vital role to diversify a portfolio and provide a cushion against stock market volatility. As we all know, stock prices can fall as fast as they rise. A bull market can turn into a bear with little warning. If you're a cautious investor, overloading your portfolio with equities could expose you to more risk than you're comfortable with.

"I certainly empathize with investors since rebalancing usually seems counterintuitive at the time when it promises to be most effective," Mr. Kinniry said.

"It can be difficult to implement from a behavioral standpoint and requires incredible discipline. With the U.S. stock market up 198% since its trough, coupled with the considerable uncertainty about the impact of rising interest rates on bonds, it is understandable that investors may have a hard time selling stock funds and committing more capital to bond funds in order to rebalance their portfolios."

Check your premises—and take action if necessary

With all this in mind, now may be the time to take a close look at your investment strategy ... and at your underlying assumptions. Go back and think about those three questions we posed at the beginning of this article.

"Remember," Mr. Kinniry said, "rebalancing is not about maximizing returns, reversion to the mean, or market forecasts—it's about maintaining the risk-and-return characteristics of the portfolio an investor selected based on his or her unique time horizon, risk tolerance, and financial goals."

To give yourself the best chance for success, Vanguard offers four timeless investing principles:

  1. Have clear, appropriate goals. Your success shouldn't depend on unreasonable investment returns or impractical spending and saving requirements. Learn more »
  2. Create a broadly diversified portfolio. Your asset allocation should align with your portfolio's overall objective. Consider choosing a mix of stocks, bonds, and cash investments that align with the level of risk that you're comfortable with. When choosing investments in each asset class broadly diversified investments limit risk exposure and can dampen volatility. Learn more »
  3. Minimize costs. Costs are the one element of investing that you can control. The lower your costs, the greater your share of an investment's return. Learn more »
  4. Maintain discipline and a long-term perspective. When it comes to investing for your retirement this can be the most difficult principle to achieve. Sticking with your long-term financial plan and tuning out the daily market noise can be crucial to achieving your financial goals. Periodic rebalancing will be necessary to bring the portfolio back into line with the allocation designed for the objective. Learn more »

Notes:

  • All investments are subject to risk, including possible loss of the money you invest.
  • Past performance is not a guarantee of future results.
  • The performance of an index is not an exact representation of any particular investment as you cannot invest directly in an index.
  • Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
  • An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.
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