Rebalance your portfolio or not?

As an individual investor you face the prospect of protecting your investments with little or no support from a professional advisor.  If you are like me, you have to ask yourself what should I do about rebalancing my assets?  Should I sell my winning stocks now to rebalance into lower yielding bonds?  Should I let me gains ride and rebalance when bonds have made some of a rebound?  Only you can truly answer these questions and only you know if you feel comfortable in rebalancing your assets in your portfolio.

Chances are if you do own a mixture of stocks and bonds your stocks are outperforming your bonds by a significant amount.  Over the past year, the S&P 500 index was up 16% prior to the government shutdown and will most likely go back to the pre-crisis levels provided Congress does not have another showdown on the debt ceiling limit.  If that happens your guess as to what will happen is as good as mine but chances are the stock market will go down and the yield on US Treasuries will go up due to the inability of Congress to act and thereby creating an environment where it will cost the US more to borrow.

But as of today I can honestly say I am not certain I would own bonds in my portfolio or at least I would not add to that position.  Why you ask?  The current yield on a ten year Treasury is about 2.6%.  While that is up from the start of the year that return will not even keep pace with inflation over the long run.  If you were to look at bonds for your portfolio I would highly recommend a high percentage in high quality corporate bonds and a small percentage in riskier high yield bonds.  This will help diversify your portfolio not only between stocks and bonds but a mixture of these kinds of bonds will further diversify your overall portfolio as well as the portion of your portfolio invested in bonds.  Unless you are actively buying and selling bonds looks for high quality bonds that have attractive interest rates and hold them until they mature eliminating your need to adjust the bond’s principal for rate sensitivity.  Do the same for high yield bonds but pay particular attention to the company’s financials because in these bonds your interest payment and principal payment may both be at risk at a higher degree than high quality corporate bonds.

I recently read an article in Money magazine where a portfolio of 70% stocks and 30% bonds were purchased and examined over a 187 year period between 1826 and 2012.  The result of not rebalancing surprised me to a great deal as the adjusted for inflation return on the rebalanced portfolio was just 0.23% better than the portfolio where nothing was done.  Depending on the size of your portfolio that small of an amount would generally have been eaten up by the costs and fees associated with your rebalancing.  After all it is not free to buy and sell these assets in order to get to your desired rebalance ratio.  Clearly rebalancing on an annual basis may not be the best strategy and in most cases for us as individual investors may not be practical on a cost basis as well.

While buy and hold may be out of favor with many I am starting to take a hybrid approach to investing.  Warren Buffett is the best investor in the world and is known as a value investor.  His track record speaks for itself and I will not even attempt to explain his in depth strategies.  But a basic and simple approach is find a company you understand their core business.  Do your homework on the business and see what the numbers tell you.  And this is a Buffett aspect of the research but does  the business enjoy a wide moat meaning it has distinctive advantages that is has created over time that will give it advantages over its competitors.  And finally is the stock selling at an attractive price or at a discount.  Or once again to take an example from Buffett what is the stocks intrinsic value?  Once you know the stock’s intrinsic value you will be able to determine if it is selling at a discount, premium or if it is fairly priced.  Now do not place all of your emphasis on the price of a stock at the time you are doing your research.  It is totally acceptable to buy a stock at a premium if you believe in the core fundamentals, management and business in general and from doing your research you believe the stock will go even higher.  If you have done your research and are comfortable with a company’s stock there is no reason why you cannot buy the stock as a long term investment or as I like to say a buy and monitor approach.  It is very important to keep informed on the businesses you invest in and at any point you see something that causes you to be concerned it may be time to sell.  But rebalancing for the sake of rebalancing may not make sense when things are all going according to your original investing plan.

Now if you have a portion of your portfolio in quality bonds and you are comfortable in your stock positions, there is no need to rebalance what appears to be working.  But if you want to get back to your desired ratios try this.  Instead of selling one asset to buy another, when you invest new capital into your portfolio use the new funds to buy the asset class that is no longer at the desired ratio of your desired portfolio balance.  For example, say you are needed to buy bonds because the stock market has outperformed bonds during the year.  Do not buy and sell current assets but use new capital to buy new bonds and by doing this you will help to bring your portfolio back to the desired ratios.  And if that still does not get you back to where you are comfortable try rebalancing every three or five years to avoid unnecessary costs and fees.  But chances are you will be able to adjust the portfolio balances by investing in the lagging asset class for a few years with new capital while you continue to let the winners continue to win and adding quality assets in the lagging asset class.

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