Updating Saturday and Wednesday.
A good friend and reader sent me an email and asked a most interesting question about “re-balancing” your portfolio. I thank her for a great question, and encourage all of my readers to interact, send in questions or make comments like Abraham does. I think that will keep us all thinking, and hopefully having fun!
Rebalancing is an activity that you would do periodically, IF you believe that an ASSET ALLOCATION strategy is important to your financial plan. Conversely, if you don’t believe in “asset allocation”, then you don’t have to worry about rebalancing.
Asset allocation is a form of diversification, meaning “don’t put all of your eggs in one basket”. Diversification means putting some of your assets in multiple asset classes (stocks, bonds, real estate, gold, international, etc.), but it does not specify how much of your assets to put in each category. The theory is that usually not all asset classes go down together. By diversifying across asset classes, if the stock market goes down, the Fed will lower rates and your bonds should go up (be careful, when the Fed is raising rates, your bonds will go down).
Asset allocation models are a form of diversification where specific percentages are targeted to be held in certain asset classes.
We begin with a traditional 60% stock / 40% bond allocation. In the next year, stocks gained 20% and bonds only gained 5%. The total weight or percentage of the stock component of your portfolio is now 63% of your portfolio, and the bond component has shrunk to 37%. In one year, this is not a big deal, but after 3 or 5 or 7 years, one could get substantially out of the 60 / 40 asset allocation, if one thought it was an important part of your investment strategy. You would then sell some on your stock holdings and buy bond holdings with the proceeds, to rebalance your portfolio back to the model of 60% stocks and 40% bonds. That’s it, asset allocation and rebalancing.
I have seen some models where the asset allocation varies with one’s age, for example:
Age Stock Bond
- 20’s 90% 10%
- 30’s 80% 20%
- 40’s 70% 30%
- 50’s 60% 40%
- 60’s 40% 60%
- 70’s 30% 70%
That’s a nice simple model that looks somewhat reasonable. It assumes that the stock market will rise in the long run, and even if it takes a drastic tumble (and you hold your stocks like your brokerage house advises, which enriches them and not you, they take their 1% management fee out of your mutual fund whether it goes up or down!), you will have time to recover, and you will still come out ahead of holding all bonds. The reason you reduce your stock holdings over time is that the recovery time can be very long (many times 10 years to get back even), and older folks don’t have that much time to wait on the recovery.
I AM NOT A FAN OF ASSET ALLOCTION STRATEGIES THAT IGNORE THE MUCH MORE IMPORTANT IMPERATIVE OF MANAGING YOUR ASSET ALLOCATION TO THE VALUATION LEVELS OF THE MARKETS YOU PARTICIPATE IN, usually the stock and bond markets, but sometimes the real estate and gold markets.
Valuation levels always trump asset allocation models. Worry about the valuation level of the asset you are buying first and foremost, and pursue an asset allocation model as a secondary objective.
Right now, bonds offer little value. A 10 year treasury bond is priced sky high and offers a historically low yield of 1.5% a year for the next 10 years. That would be like buying a house at the peak of the housing bubble, which did not work out well over the next 10 years.
The bond market is so highly manipulated by the central banks around the world right now that I just don’t trust them. I have been wrong about bonds for a good 5 years, but I’m ok with that, and I won’t be wrong forever. I can make money in the stock market. With Japan and Europe forcing interest rates negative, money from international is moving to the US for our low yields, which look good to them.
Why would anyone sell stocks and buy bonds right now, when bonds offer the lowest yield and highest price point in history? This does not make sense to me. If you were in the housing market, would you rent (time out) for a couple of years and wait for the bubble to pop, and buy a house when prices return to more traditional valuations? Hopefully so. In the financial markets, the equivalent would be to go to the money market (time out) for a couple of years (or 1 year CD’s, or 1 year treasury bill, definitely NOT short term bond funds).
What good would it possibly do you to buy into an asset class that is over-valued and on its way down, for the purpose of achieving diversification? I was almost 100% in bonds from late 1999 to 2010 and did very well preserving assets and making some money. Others did better if they were nimble enough, but for working full-time I picked a good asset class to ride out the carnage.
I have a few individual bonds, but they were bought in the 1990’s and early in the 2000’s back when bonds had value for the long term. These are tax free municipal bonds that yield 4-5% and they have proven safe. I don’t hold any out of California or Illinois because I have not trusted their deficit spending profile for decades and all of my bonds are bought to hold until maturity. Looking back, maybe I should have bought more bonds when I did. However, I could not foresee this economic collapse and the extent and duration of FED intervention in the bond market, which has now driven bonds to an extreme of over-valuation (unless you can hold the bond until maturity and be satisfied with the yield you are receiving). I did not foresee that I would have to shape up my portfolio to retire 15 years ahead of time. Thinking about it now, I don’t think it was a big mistake on my part necessarily, as I think the condition we find ourselves in was UNFORESEEABLE. I thought I could always get a 5 year CD yielding at least 4%, and I was wrong. At this point I do not want to compound the situation by making another mistake.
There are a number of mutual funds called “balanced funds” and they attempt to do some asset allocation for you. By their charter they are required to hold some in bonds and some in stocks. Their charter may require that they hold between 30-50% in bonds and 50-70% is stocks, so they have some latitude. They may have flexibility to invest up to 30% of the funds internationally. I am not a fan of those funds when they are required to hold at least 30% in bonds and bonds are not a good value (at least not US Treasury bonds).
I am a fan of diversification, but I advocate achieving that diversification over time, acquiring the assets in a class when that class represents a good value, then holding the asset.
I don’t think you should try to achieve diversification overnight if that means buying assets in different asset classes, some of which are clearly not a good value today.
Sometimes we may find ourselves where NO asset class represents a good value. In that case we have to just wait until good value appears.
There is no change is the picture below. The market had a nice run from the Brexit low in late June up into late July, and I called that well if you go back and read my comments in late June and late July. The market became overbought so I sold out, and I did not miss much runup, but I protected myself from any loss. Now I’m sharpening my buy list for the next pullback, whenever that is.
Oil has been weakening and with it the oil companies. Oil is down from 53 to 45 over the last couple of months, as the summer driving season comes to an end. This is from the latest EIA petroleum status report: “A rise in inventories is making for a drop in oil this morning. Oil inventories rose 2.5 million barrels in the August 19 week”. It may take another month or two, but I’ll be watching.
The domestic banks have picked up recently, based on anticipation of the Fed raising interest rates, which would help banks with their “net interest margin”, the spread between their borrowing cost and lending rate. When rates are a little higher, spreads can grow a bit, and banks make more money.
We see below that both the RSI and MACD are still declining, indicating market complacency or weakness, but not weak enough to entice me in yet. I remain on hold.
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Rich Comeau, Rich Investing