OCEAN CITY – For just a minute, think of your long-term financial strategy as a cross-country car trip. You know where you want to end up and you have a pretty good idea of how long it should take to get there. At the same time, you know that here and there, you’re going to run into heavy traffic, inclement weather, detours and other obstacles to your safe and timely arrival. And of course you’re always looking for opportunities to reach your destination in the smartest, easiest way. As an intelligent traveler, you will probably consult a GPS system to look for better routes and to check weather reports and traffic updates for potential problems, and maybe visit a local Web site to make sure there’s no roadwork along the way.
These easy steps can make a trip relatively smooth and surprise-free. Similarly, there are moves you can make as an investor that will help enable you to avoid a number of pitfalls and take advantage of potential opportunities. One of the most important is regular rebalancing—adjusting your ratios of stocks, bonds and cash investments to their original targets so that they reflect the strategy you have decided best suits your goals, time horizon and risk tolerance.
The market volatility of the past couple of years shows pretty clearly why rebalancing is a sensible idea. Between October 2007 and March 2009, stocks (as measured by the S&P 500) declined 57%. At the same time, bonds posted gains, and many investors increased their cash holdings. As a result, the percentage of stocks in most portfolios shrank markedly over this period, while in the majority of cases bond and cash allocations grew. When the markets alter the shape of your portfolio in this way, you end up with less potential for the kind of long-term growth that equities have historically provided, as well as a greater exposure to risk. What’s more, an out-of-balance portfolio can undermine your efforts to remain genuinely diversified.
The end result is that the markets gain an undue influence over your financial strategy. “For an asset allocation strategy to be successful, you need to be in control of it and adhere to it over time,” says Ash Rajan, Head, Investment Policy, Investment Management & Guidance for Merrill Lynch Global Wealth Management. “That’s why, when market currents cause your allocations to drift from your targets, it’s important to review your portfolio regularly.”
Shifting your stock, bond and cash holdings back to the allocations you’ve targeted is an exercise you should undertake with your Financial Advisor. You can begin by looking at which assets have overperformed and which have underperformed during a set period of time. Consider shifting funds out of asset classes that exceed your targets—and are thereby growing into a larger percentage of your holdings—and moving them into under-represented asset classes. What determines when you need to either add to or subtract from a particular asset class? “Investors can expect to tolerate a short-term fluctuation of 5% from their allocation model pretty well, but much more than that indicates a need for change—or at least to start a dialogue with your Financial Advisor,” Rajan advises.
The most straightforward rebalancing strategy is to sell some of your best performers and use the proceeds to purchase undervalued assets—either expanding positions in securities you already hold or choosing different investments in the same asset class or sector. Alternatively, you may decide to devote the proceeds from your sales to asset classes that are underrepresented in your portfolio, with the goal of rounding up your diversification.
In fact, rebalancing can be an opportunity to take advantage of investment opportunities. As you consider which positions to sell and purchase, look at what’s happening in the marketplace. Talk to your Financial Advisor about sectors, asset classes, geographical regions and market trends that are consistent with your strategy and could have a favorable impact on your portfolio. In addition, it can be an opportunity to discuss any material life changes such as marriage, divorce, death, retirement, education or inheritance, as well as your attitude toward risk and any potential need for changes in your asset allocation.
How often is ‘regularly’?
While actively rebalancing is especially important following a prolonged period of market volatility, many financial professionals recommend that you get on a regular schedule to revisit your portfolio, irrespective of market conditions. Rajan recommends realigning your asset allocation annually. “There’s no magic to a 12-month interval, but it does represent a happy medium between too often and not often enough,” he says. “It also syncs up well with other market assessments, such as year-to-date performance.”
In addition to the annual review, he suggests checking your portfolio regularly throughout the year and making adjustments if your allocation to a given asset class shifts by more than 10 percentage points. “When you see movement to that degree in a position, it warrants a response,” he points out. “Establishing rules such as this help you respond with strategy to market movements rather than from emotion. This was one of the big lessons from the market of late 2008: When conditions are unusual, you may need to recalibrate your response.” At the same time, he advises weighing carefully the need for frequent full-scale overhauls because the transaction costs may offset the benefits.
However often you choose to rebalance, it’s important to commit to a regular review. “This process shouldn’t be viewed merely as an action, but as a mind-set,” Rajan emphasizes. “It’s a conscious step that will help you approach your portfolio in a disciplined way. And that’s valuable in any market.”
(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)