TCS Daily

Rebalancing Act

By James K. Glassman - June 25, 2002 12:00 AM

The worst disasters for small investors can almost always be traced to the same source: a lack of diversification.

If you own a portfolio of stocks that looks like the U.S. economy -- or the world economy, for that matter -- you may have a few rough years (this one, for instance), but it's highly likely you'll do well in the long term. Investors who own too few stocks or concentrate in too few sectors, on the other hand, are begging for trouble. Since stocks rarely go down (or up) at the same rate, some sectors perform profitably while others do miserably. In 2001, for example, the small-cap stocks of the Russell 2000 index rose 23 percent while the large-cap stocks of the Standard & Poor's 500 fell 12 percent. Among mutual funds, Third Avenue Real Estate Value rose 18 percent while Deutsche Flag Communications dropped 30 percent. When you own companies of different sizes and in different industries, growth stocks and value stocks, domestic and international, the ups and downs tend to even out and your investment ride is a lot more comfortable.

But you already know that. What you may not know is how to ensure that, once you have set up a diversified portfolio, it stays that way. The answer is a process called rebalancing. It's absolutely necessary, but it's also unnaturally difficult -- not to mention annoying and, if you aren't careful, expensive.

"It goes against human nature," says Francis McKinniry, an investment counseling executive for the Vanguard Group, the giant mutual fund firm based in Valley Forge, Pa. "You're telling people to sell shares from their best-performing asset class and put them into their worst-performing asset class. It's the opposite of chasing returns."

True. Rebalancing means adjusting your investments every so often to keep them properly diversified. Like tires, stocks can hit bumps in the road that throw them out of kilter. If you leave them that way, you're bound to have an accident. Imagine you owned a $100,000 stock portfolio in January 1998: $80,000 in an S&P index mutual fund and $20,000 in a great new company you had heard about called CMGI Inc., a holding company for a bunch of hot Internet firms. Clearly, you were overloaded in CMGI, but you still had decent ballast from the rest of the market.

By the end of 1999, the value of your CMGI had soared to an incredible $1.4 million while the S&P part of your account had risen to $131,000. Your portfolio was now worth more than $1.5 million, but CMGI represented nine-tenths of it. You had practically all your eggs in the CMGI basket -- a hugely risky proposition even if CMGI were a stodgy bank stock instead of an Internet highflier. It's time to rebalance -- in fact, past time. But it's hard to sell such a big winner, so you leave your portfolio as is. Within a year, CMGI drops from $138 a share to less than $5. On June 14, 2002, it closes at 57 cents. Your CMGI is now worth less than $6,000; your total portfolio, $108,000.

Imagine instead that you had decided at the end of 1999 to restore your original allocation -- 20 percent CMGI, 80 percent S&P -- through rebalancing. You do this by selling about $1.1 million worth of CMGI and using the proceeds to buy S&P index shares. Even after the devastation of 2000 and 2001, your total portfolio would amount to about $830,000.

Of course, this is an extreme case, but nearly every stock portfolio includes a gigantic winner or a gigantic loser, and the distortions -- even if you own mutual funds instead of stocks -- can produce dangerous situations.

This is precisely what happened to employees of Enron Corp. Their 401(k) plan allowed them to choose from among about 20 mutual funds, and half of the amount they invested was matched in Enron stock. So a smart employee might have started with two-thirds of 401(k) assets in an S&P index fund and one-third in Enron. But as Enron stock quadrupled in three years, the employee's account became one-third S&P and two-thirds Enron. Enron workers under age 50 could not fix the problem by rebalancing their 401(k) plans because they weren't allowed to switch out of company-provided Enron stock. But, if they had the money, they could have boosted their overall S&P proportion by purchasing shares in a taxable account. In the end, of course, Enron went bankrupt (it was recently trading at 67 cents a share) and most employees lost a huge chunk of their retirement money.

I calculated another example: a portfolio allocated 50 percent to the S&P, 25 percent to the small-cap stocks of the Russell 2000 index and 25 percent to intermediate-term (maturity in about five years) U.S. Treasury bonds. This is the kind of distribution that should diminish volatility and give you a smooth ride -- but not in every year.

Say an investor begins in 1996 with a total of $40,000 divided among the three types of assets. By the end of 1998, the total rises to a delightful $71,330, but the allocations are a mess because large-cap stocks have far outpaced small-caps and bonds. The S&P part of the portfolio is worth $45,750, or 64 percent -- not 50 percent -- of the portfolio. Again, it's time for the investor to rebalance, in this case by selling about $10,000 in large-caps and buying $4,400 in small-caps and $5,600 in bonds. With that rebalancing, by the end of 2001 the total account is worth $83,195. Without the rebalancing, it's worth $79,422.

That's not a gigantic difference -- about 5 percent. But volatility, or risk, over the period was lower with the rebalanced portfolio. As McKinniry of Vanguard put it, "the primary purpose of rebalancing is to manage risk, not to maximize returns." His own research, for example, looked at a portfolio that was half stocks, half bonds, from 1960 to 2001. If he rebalanced the portfolio every six months to bring allocations back to 50-50, then annual averaged returns were 9.6 percent; without rebalancing, 9.4 percent. Not much difference.

The rebalanced portfolio, however, was far more stable. It suffered negative returns in only two-thirds as many 12-month periods as the portfolio that wasn't rebalanced.

But rebalancing is tough, for three reasons:

1. As McKinniry says, it's unnatural. It would be hard to bring yourself to sell CMGI at the end of 1999 after it had risen 70-fold. Why not stick with a winner? That sounds sensible, but the buy-and-hold strategy works best when coupled with a diversification strategy to dampen risk. Very simply, you should never own too much of one stock, one industry or one asset class (that is, large-cap growth stocks or international short-term bonds).

2. It can be expensive. When you sell stocks, you have to pay capital gains taxes of up to 20 percent (and that's just the federal take). But you can reduce the pain by donating the shares of your big winners to charity or by trying to rebalance only by adding new money to your lagging assets (difficult in the CMGI example above unless you happened to have $5 million hanging around). Or you can simply try to keep the most volatile portion of your holdings in a tax-deferred account, where making changes carries no tax penalty. But, says McKinniry, interviewed in In the Vanguard, a newsletter for clients, "you should never allow your taxes to drive your goals."

3. It's a pain in the neck. True, but the alternative is worse. At any rate, don't be dogmatic in rebalancing. Once a year, check your allocations. If an asset has strayed by about one-fifth (in other words, if large-caps are supposed to be 50 percent of your portfolio but have risen to 60 percent), then rebalance; otherwise, wait till next year. The same applies to individual stocks and mutual funds within an asset class.

Initial allocations depend on personal circumstances. In general, the farther you are from needing your money, the more stocks you should own. If you're in your twenties or thirties and are investing strictly for retirement in your sixties, then nearly all your money can go into stocks (as long as you can sleep at night), but most investors in their fifties should start moving into bonds. Some investment advisers recommend owning bonds even in very long-term portfolios. Sanford C. Bernstein & Co., for example, tries to build balanced accounts of stocks and bonds for its clients that perform almost as well as all-stock accounts but with one-fourth less risk.

Why is risk important? Because when a portfolio loses a lot of money in a year (even if the money isn't needed for another decade), investors often panic and do the wrong thing, like sell shares in good companies. Ups and downs cannot be avoided in investing, but they can be made more gentle. Rebalancing helps.

Over time, nearly ever investor should be shifting from stocks to bonds and cash (that is, money-market funds, Treasury bills, bank certificates of deposit and the like). If your allocation is 90 percent stocks and 10 percent bonds at age 45, it should be closer to 75 percent stocks, 20 percent bonds and 5 percent cash at age 55. Since stock gains exceed bond gains in normal years, your rebalancing in this case has to be especially aggressive to build up bonds.

One alternative to doing the rebalancing yourself is owning shares of a mutual fund that is tailored to a retirement date. Fidelity Investments launched a series of such funds in 1996 called Freedom 2010, 2020, and so on. Since Freedom 2010 is for older investors retiring in about eight years, a recent allocation was approximately 45 percent stocks, 40 percent bonds and 15 percent cash (using Fidelity mutual funds for all the holdings). Freedom 2040, targeted to younger investors, had 85 percent of its assets in stocks.

Over time, Freedom 2040 will evolve through rebalancing to look like Freedom 2010, reducing its likely returns but also its volatility. Just remember that rebalancing is essential but often frightening. Right now, for instance, a portfolio that was established a few years ago almost certainly has become overweighted in bonds, small-caps, precious metals and value stocks. To rebalance may mean selling those assets and buying high tech, large-caps, pharmaceuticals and aggressive growth companies. Are you ready?



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