Portfolio Management 101 > Portfolio Rebalancing

It’s a New Year, Reflect and Rebalance

Portfolio Rebalancing Rocks

It’s the beginning of a new year and many of us find ourselves reflecting on the year gone by, thinking about both our accomplishments and failures. The list of New Year’s resolutions created just one year ago has been long forgotten and replaced with a new list, equally as ambitious as the previous list and receiving an inordinate amount of our attention for at least the next 3-4 months. After that, it’s back to life and business as usual.

For investors who added to their equity positions this year, this is a good time to pat yourself on the back and enjoy one of the best returns we’ve had in the US equity market in quite a while. The S&P 500, as measured by the iShares S&P 500 Index ETF (SPY) had a return of 32.31% according to Morningstar.com. For bond investors, unfortunately, 2013 was the end of a multi-year party. The iShares Core Total Aggregate US Bond ETF (AGG) had a return of -2.02%, after having gained 4.21%, 7.84%, 6.54%, and 5.93% for 2012, 2011, 2010, and 2009 respectively.

Looking forward to 2014, most forecasts predict positive returns for equities once again but with actual returns being closer to 10%, not 30%. In other words, don’t expect a repeat of 2013. For bonds, the prognosis continues to be a very challenging environment as interest rates creep up, with the eventual benefit of finally being able to invest in a fixed income security with a yield above that of inflation. At least until the rate of long anticipated inflation begins to pick up.

As for new year’s resolutions and your investment portfolio, if you do nothing else the least you should do is rebalance. Rebalance your equities back down to the appropriate level and increase your fixed income to its long-term strategic allocation. This may sound counterintuitive in light of the forecasts we just provided. You may be wondering why we are suggesting to reduce equities, when we just mentioned that equities should perform well. Looking at it another way, if you sell the portion that increased and buy more of the portion that decreased you are essentially buying low and selling high. Too many investors do the opposite, chasing returns by adding to those asset classes that have recently performed well and selling asset classes that have performed poorly. Don’t fall into that trap! Be more like the institutional investors that David Swensen discusses in his book, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment.

Buying Low and Selling High

This past year, the value of the equity portion of your portfolio has increased considerably depending on how that portion of your portfolio was invested. Assuming it was invested entirely in US Equities through the iShares S&P 500 Index ETF, that portion of your portfolio would have grown by 32.45%. Meanwhile, the portion of your portfolio invested in fixed income, assuming exposure to fixed income through AGG, that portion of your portfolio decreased slightly. The resulting weighting of your portfolio is now overweight to equities compared to how it was allocated at the beginning of 2013. We’ll explain.

Let’s assume you have a $100K portfolio, of which 60% was invested in SPY, and 40% was invested bonds through AGG. Lets further assume that this 60/40 split is consistent with your investor profile and risk tolerance. (For more information on your Investor Profile, take our quiz). At the end of 2013, the equity portion of your portfolio would have grown from $60,000 to $79,386, while your fixed income portion would have decreased to $39,192, from the original $40,000. If you refer to the table below, you will notice that the new percentage allocations are 67% for equities and only 33% for fixed income.

Effect of Returns on Asset Allocation


This is now a more aggressive portfolio than that which you started with and is also much riskier. A big mistake would be to leave the portfolio as is and a bigger mistake would be to add more to equities. In order to maintain the portfolio at the same risk level as the 60/40 original portfolio, you would sell $8,239 worth of equities (at a higher level than you started) and reinvest the proceeds into fixed income (at a lower level than where you started), as shown below. Buy low, sell high, resulting in the a new portfolio with the original 60/40 allocation.

Rebalancing back to 60/40




Discipline and Frequency

By doing this on a regular basis, you ensure that your portfolio reflects your individual investment preferences and risk tolerances and ensures that you do not take unnecessary risks inadvertently. Too often investors do not adjust portfolios and the equity portion continues to become a larger part of the portfolio until there is a big correction in the markets that result in massive losses. This was a common occurrence during the equity market meltdown in 2008.

We recommend that portfolio rebalancing occurs quarterly but we also recognize that sometimes the percentages do not move much over such a short period. That is why it is so important to make sure that portfolios are rebalanced at least annually, and what better time to do this than either late in the year (for possible tax benefits), or the beginning of the new year.

So as you are preparing your list of new year’s resolutions make sure that portfolio rebalancing is at the top of the list. It does not take long and once done, you can check it off your list and forget about it for the rest of the year – if you prefer.