The term "rebalance" makes investing sound as simple as having your tires rotated or your alignment checked. And the basic concept is exactly that straightforward. But with interest rates stuck at historic lows, investing experts say it's become harder to keep allocations in proper balance, and that it may become even more challenging to work with traditional "equity versus fixed income" formulae as rates go higher.
True, there is still a simple strategy that holds. It makes sense to rebalance at regular intervals so your investments are aligned with your long-term financial plan. That generally means remixing the upside potential of equities with guaranteed returns of fixed income when one or the other gets overinflated in your portfolio.
But there are two simple steps to rebalancing. And a third that is incredibly difficult.
Step one: At the start of your investing life, decide your ideal mix of equity and income based on your appetite for risk and your long-term goals.
Step two: As you drive your investment "vehicle" toward its goal, check periodically, at least once a year, to see how your own mix of investments holds up as markets change. Then, adjust them in age- and risk-appropriate ways. Tax time is a popular time to perform the checkup and make contributions to retirement funds.
There is a step three--and it is way harder. As you complete your tuneup, try to sell high and buy low. Rebalancing is supposed to give investors the discipline to do that. But the old formula of shifting between stocks and bonds is just not working as it once did.
"I would move away from the price risk of bonds, and I would be worried about adding to them right now," says Charles Ellis, former chairman of the Yale Endowment who is now on the investment advisory board of Rebalance IRA, which offers individual advice and tools for retirement account holders. "I would be looking for another form of income. When it comes to fixed income, you have to consider if I really need that, and if I can I get income in any other way."
For example, he notes that the common stock dividend for AT&T is about the same as its bonds, at just over 4 percent. Buying the common stock probably makes more sense since common-stock dividend payers have been boosting payouts from their historically high cash reserves. Bonds, with fixed yields, do not offer that advantage.
In keeping a balanced portfolio, debt securities have nearly always provided a natural hedge: Bonds usually gain in value when stocks go down. Their yields rise proportionately when stocks go up in an improving economy. For decades, rebalancing provided a virtuous circle that way, and as a result, it kept people from letting emotions rule investments, says Ellis. That rule still holds, even if the asset mix is changing.
The rule of thumb has traditionally been "your age minus 100." It tells you roughly how much equity you should have. Doing that math, at age 40, your equity should be 60 percent and the rest should be fixed income. At 60, those numbers are flipped, with 60 percent in fixed income and 40 percent in stocks. Following the crash of 2008, those who followed the rebalance rule "have done very well," says Cam Albright, director of asset allocation at Wilmington Trust Investment Advisors.
Is there a "new normal" for rebalancing now? Normal rebalancing rules would suggest that with a 25 percent gain in stocks since the start of last year, investors should start lightening up on equities by the same percentage. Meanwhile, they should be buying bonds to restore that balance. But bond prices are so high, and yields so low, that many investing allocation experts are leery of loading up on more fixed income, especially with the Federal Reserve is in its sixth year of keeping interest rates low, and rates expected to rise when the policy ends.
"We have looked more at the income-producing side of equities and recognize equities as good income-producing properties," says Albright. "Unlike bonds, they can increase dividends. They grow up with time. There is a lot of benefit right now to think about the income coming about of equity and not just from fixed-income securities. It's a transition people have had to make the last couple of years."
Equities and bonds both have "principal risk," he adds. "Laddering" with a series of short-term bonds is one way to avoid the problem, since low-duration debt reaches maturity in a short time, Albright says. Those one- to five-year securities pay little in yield but at least investors recover some or all of their invested capital when the security matures, unless they overpaid for the bonds in the secondary market.
As a result, dividend-paying stocks are taking up a larger share of the notional "income" in some allocations models. That's understandable, at a time when the average stock dividend on the Standard & Poor's 500 index is higher than the 10-year Treasury bond. But it's not an even trade; stocks are still almost always a riskier proposition than bonds.
Some risk-averse investors who are worried about stocks and bonds are leaving the securities world entirely to buy insurance-based products such as income annuities and stable value funds, which are insurance "wrappers" that hold their value but offer very low yield and almost no upside for insuring principle.
"People are getting more comfortable with income annuities as part of their overall retirement plan," says Phil Michalowski, vice president of annuity product marketing for MassMutual. "People like the security and certainty."
When the crash came in 2008, those products did, indeed, hold value. But without a government bailout of some of the major insurance companies, those insurance products, too, might have failed to pay. It's important to consider the financial ratings of the insurers in buying these stable-value or income products. The downside of annuities is that they are not tradeable securities that can be easily sold in the market. The sector is also hampered by concerns over high fees and regulatory actions related to aggressive sales tactics. But increasingly, advisers are recommending them as an investment strategy that might take up more of the income portion in a balanced portfolio, says Michalowski.
Rebalancing focuses on the long term. Despite the shifting views on how to rebalance in a low-rate environment, most financial advisers see merit in the practice. Wealth managers who advise high-income investors take pains to make sure they rebalance to suit clients' needs. A growing number of Web-based allocation experts are offering the service to middle-income investors. Rebalance IRA offers its service with a free initial individual consultation with an adviser who helps determine goals, and then follows this up with allocations based on the views of high-level financial strategists like Ellis, who guided Yale's massive endowment with a rebalancing strategy based on diversified investments that provided far above-average returns there. But Ellis says personal advice and individual goal-setting are key components of successful rebalancing strategy.
"There is no such thing as an average investor, but regardless of who you are and what place you are on in the investing spectrum, rebalancing will help," says Wilmington's Albright. "A disciplined approach, and sticking to asset allocations that you review on a periodic basis, will stand you in good stead no matter how conservative or aggressive you are."