U.S. stock markets begin 2014 near record highs, with 2013 recording the best annual return for the S&P 500 index since 1997. With the current stock bull market approaching five years old, financial pundits are still predicting further gains for this year, albeit much more modest, and probably not without some noticeable market swings up and down.
Long-term investors following the investor’s ethos ‘don’t put all your eggs in one basket’, needn’t concern themselves with market swings, or even year-to-year performance. These investors follow a widely popular strategy of portfolio asset allocation and systematic rebalancing. If you are not already following this strategy, a few simple changes will provide you some protection from market volatility over the long-term.
Simply, asset allocation is based on the notion that stocks and bonds perform differently. Portfolio asset allocation aims to balance the investor’s potential risks and rewards by allocating a percentage of investment funds into various asset classes; in broadest terms, either stocks, bonds, or cash. The right amount of ‘eggs’ in each basket is the investor’s target asset allocation mix based on the investor’s goals, time horizon and risk tolerance.
And because stocks and bonds perform differently given market and economic conditions, over time, an investor’s current asset allocation will drift from their target allocation – requiring the investor to ‘rebalance’ or buy and sell to redistribute assets back to the target mix.
Systematic rebalancing prevents the distortion of an investor’s desired risk-reward balance of the target portfolio allocation that occurs when one asset class significantly out-performs other asset classes and subsequently dominates an investor’s portfolio.
Think of the 2000 dot-com tech bubble collapse or the 2008 financial crisis – these particular events had significant stock market increases prior to the collapse – these run-ups skewed many investors’ risk-reward balance, and the investor, in effect, had ‘too many eggs in one basket’ at the time of market collapse.
Given the higher returns run of the stock markets this past year – rebalancing may be your best course of action. While it may seem counter intuitive to scale back a hot performing asset class, by rebalancing, an investor is in fact, selling high, and using the proceeds to maintain the desired risk-reward exposure based on risk tolerance and time horizon to goals.
However, investors with a shorter time horizon should give pause before rebalancing.
Your Risk Tolerance
The Federal Reserve has indicated that it will likely raise interest rates starting in 2015 creating headwinds in the bond market; in addition pundits have argued that low interest rates have artificially propped up the stock market. As such, the potential for increased interest rates looms ominously over the financial markets. This uncertainty combined with continuous rhetoric and speculation creates so much confusion that it serves to fuel market swings in both stocks and bonds.
How much, how fast, and exactly when the Fed raises interest rates is still anyone’s best guess. To the long-term investor this is just ‘noise’ to simply ignore and stay on course with systematic rebalancing.
But, if this ‘noise’ keeps you awake at night, then it is likely that your tolerance to risk or time horizon has changed; in this case, don’t re-balance… Re-allocate.
As mentioned earlier, a portfolio asset allocation mix should be a reflection of the investor’s risk-reward balance based on an investor’s goals, risk tolerance and time horizon. If your risk tolerance and time horizon has changed, since establishing your current asset allocation mix – invariably unavoidable as an investor ages through life and work paths – portfolio re-allocating, and not portfolio re-balancing may be more appropriate.
If you would like to know more, call and talk to one of MOAA’s on-staff Financial Planners, or check out The MOAA Investors’ Manual.