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Portfolio Rebalancing – Ignoring Emotions in Favor of Discipline

Through December 30, 2013, US stocks as measured by the S&P 500 have seen a year-to-date gain of 31.86%. While foreign stocks have lagged, they have also turned in excellent performance, as evidenced by the MSCI EAFE Index return of 22.64% over the same period. US bonds, meanwhile, are poised to have their first negative calendar year since 1999, with the Barclays Capital US Aggregate Bond Index down 1.92% through 12/30/2013. What is the appropriate course of action for a diversified investor?

With the rise in the stock market comes a rise in the news media’s forecasts of a continued bull market – from Barron’s to the Wall Street Journal, from CNBC to Fox Business, investors are faced with a deluge of information about how well stocks have been doing, and how well they will continue to do in the near future. We hear theories about how the recent sharp rise in stocks is going to inspire retail investors to get off the sidelines and pour even more money into stocks, helping the bull continue its charge. Between recent performance and stories like these, it is easy to become euphoric about stock investing.

However, let’s not forget that in the past 40 years, we have seen three instances where US stocks have dropped in value by approximately 50% over short periods of time (1973-1974, 2000-2002, 2007-2009). Stocks, despite whatever has happened recently, perpetually carry a high degree of uncertainty and volatility. Often, the potential for loss is amplified during periods when stocks look the most tempting. We all want to invest in high-return assets, but the statistical concept of reversion-to-the-mean often rears its head by turning yesterday’s winners into tomorrow’s losers. Instead, a disciplined approach of portfolio rebalancing can help an investor maintain a consistent risk profile, while avoiding the emotional desire to buy an asset at a high price (“buy high”) and sell an asset at a low price (“sell low”).

Let’s consider a simplified example of an investor whose Investment Policy Statement prescribes a target asset allocation of 50% in US stocks and 50% in high-quality US bonds. If this investor implemented this portfolio with $100,000 on the first day of 2013 by purchasing $50,000 of an S&P 500 Index fund and $50,000 of a US aggregate bond index fund, her portfolio value would have grown to approximately $115,000 by 12/30/2013. This $115,000 would be composed of $66,000 in the stock fund and $49,000 in the bond fund, an asset class mix of 57% stocks and 43% bonds. In order to maintain her target allocation of 50% to stocks, she would need to sell approximately $8,500 of her stock position and add $8,500 to her bond position. This strategy helps her to sell some of what has performed the best (“sell high”), and purchase some of what has underperformed (“buy low”). Additionally, by trimming her stock exposure, she has returned her overall portfolio risk back to its initial level. Absent rebalancing, this investor would be taking on a greater amount of risk than she was originally willing to take, which would be hurtful if and when the next bear market occurs.

We ask investors to not only carefully develop an Investment Policy Statement, but to periodically review their portfolio to ensure that their asset allocation remains in line with their overall tolerance for risk. Portfolio rebalancing is a vital component of disciplined portfolio management.

Dan_BDaniel Bauer, CFP® serves as the Chief Investment Officer of AllSquare Wealth Management, LLC. In this capacity, his responsibilities include developing, implementing, and monitoring investment portfolios for customers of the firm.


AllSquare Wealth Management is a Federally Registered Investment Advisory Firm.
AllSquare Wealth Management, LLC is a registered investment adviser.


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