Rebalancing an investment portfolio makes intuitive sense. And it serves to take emotion out of the picture. But it also takes judgment out of the picture. And its benefits are less obvious in a declining market.
Should you rebalance your investment portfolio on a regular basis? The answer to this question, in our view, depends on how you’ve laid out your financial plan.
Many investment counselors and financial planners strongly urge their clients to rebalance their portfolios once a year.
By that, they mean sorting your portfolio into categories, and carefully planning the proportion of assets in each category. Categories usually refer to asset classes, such as cash, bonds and stocks — or, of course, the funds that hold these assets.
But rebalancing could refer to each and every individual stock or mutual fund in an asset class too.
The rationale for rebalancing a portfolio starts by saying if you wanted and started with, say, 40 per cent of your portfolio in bonds and 60 per cent in stocks, but your stocks then doubled in value, the result would be 25 per cent in bonds. So you should sell enough of your stocks (in this case, 20 per cent) and put the proceeds into bonds, bringing bonds back to 40 per cent of the total.
This procedure has the nice effect of selling an asset that has gone up dramatically in value and reinvesting the proceeds in something that has not.
A bear market changes things
But when investors experience markets of a different character, the wisdom of portfolio rebalancing seems less clear. If your stocks decrease in value and your bonds remain unchanged, should you sell bonds to buy more stocks?
From a long-term perspective, that would make sense, of course, adding to stocks when they’re low, even if it means selling bonds that have not increased in value.
Unfortunately, that may well interfere with your cash flow if you’re looking at a shorter time frame — say, being retired and drawing income from your portfolio.
We advise a different approach to planning your finances. Rather than make arbitrary allocations by asset class, we suggest getting at least five years of your cash needs lined up in guaranteed investments — bonds, GICs, stripped coupons and so on. And invest so these securities mature when you need the money.
Use bonds for cash flow
If you’re retired, 10 years of cash needs makes more sense. But if you’re many years from retirement or other cash needs, we see no reason to add any low-interest, no-growth securities to your investment portfolio other than cash for emergencies, or for buying opportunities that may come up.
If you’re nervous about the volatility inherent in stock investing, of course, you might add guaranteed securities to calm your portfolio.
But if you have several years’ worth of cash requirements taken care of, we advise against arbitrarily rebalancing your portfolio.
Hold your winners
Investors who do practise regular portfolio rebalancing may do so by rebalancing asset classes or by rebalancing individual securities within an asset class. In the case of the latter practice, you give up on your winners.
An old stock-market maxim goes: “Cut your losers and let your winners run.” And a highly successful veteran portfolio manager once told us he learned over many years that it’s better to buy rising stocks and sell falling ones. That, of course, runs counter to conventional wisdom.
Rebalancing your portfolio when you have your cash needs well taken care of means selling your winners and adding to your losers. Less an issue with mutual funds than with individual stocks, it calls for more judgment and less adherence to ironclad rules.
As your investment time frame shortens, however, you might redeem winning stocks or equity funds and add to your guaranteed securities, effectively giving yourself a raise after success in equities.
But we don’t recommend arbitrary redemption of winning investments. We strongly urge a more pragmatic approach.
Money Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846