Dramatic stock market volatility in early February certainly got investors' attention. Now is a question of what to do about it.
So far, changes in the market have not been decisive enough to trigger a radical change in investment approach. However, underlying conditions -- including a nearly nine-year run-up in stock prices and a recent transition from a falling to a rising interest rate environment -- certainly call for some portfolio rebalancing.
Portfolio rebalancing strategies
What is portfolio rebalancing? It is the periodic readjustment of your portfolio in alignment with prevailing conditions and your long-term objectives.
Think of it like trimming a hedge. When you plant a hedge in your yard, you choose something of a size and shape that meets your needs. As time goes by, while growth is certainly a healthy sign, sometimes that growth throws things a little out of whack. Perhaps the hedge has grown bigger than you intended, or one side is now higher than the other, or one or two branches stick out more than they should. So, you trim the hedge back to the desired size and shape.
Similarly, as portfolios grow, they don't do so in a uniform manner. Stocks might outperform bonds, and some sectors of the stock market might do better than others. Some individual holdings fulfill their expectations while others lag behind, and new opportunities emerge. And so, it is necessary from time to time to rebalance your holdings back to proportions that meet your objectives and fit your outlook for the financial markets.
Since rebalancing can involve trading several securities at once, cost-effective commission rates are especially important. Several online brokers offer deeply-discounted trading commissions, so you may want to review your current commission rates to make sure they are competitive. Ideally, you can find a broker with both discounted commissions and online trading tools that can help you implement your strategies.
5 ways to rebalance your portfolio in today's market
Under normal circumstances, rebalancing can be thought of as routine maintenance, but these are not normal circumstances. A variety of unusual conditions make this an especially good time to rebalance.
An unusually long bull market has pumped up equity valuations, and some sectors and stocks have risen more than others. After years of unusually low interest rates and inflation, both are now on the rise. These factors have contributed to some wild market volatility in recent weeks.
With these conditions in mind, here are 5 ways to consider rebalancing your portfolio:
- Trim back your equity allocation. From the end of 2008 to the end of 2017, the S&P 500 nearly tripled in value. Over the past five years in particular, stock prices have grown faster than the underlying operating earnings of their companies, which is a cautionary signal. Stocks have also probably grown more quickly than other elements of your portfolio, which may mean they now represent a larger portion of your holdings than you originally intended. This may be time to trim them back down to size.
- Look at sector rotation. When the market rises, not all sectors rise at the same time. For example, information technology leads a group of four sectors that have each doubled in price over the past five years. On the other hand, the aggregate price of energy stocks has barely moved over the same period. Earnings gains also differ widely between sectors. Rebalancing should be a time to consider which hot sectors may have run their course, and which look most promising going forward.
- Cash in some big gainers. If you have a stock that has done spectacularly well, congratulations -- but now what do you do? People are often reluctant to sell a stock when it's hot, but this can result in missing the peak. Rebalancing can help. Say a particularly strong performer started out as 4 percent of your portfolio, and now represents 8 percent. That's a nice gain, but it also means your risk exposure to that stock has doubled. If you are not ready to sell it all, consider paring it back to its original 4 percent position.
- Pick off undervalued stocks. Stocks have been spectacularly volatile lately, with the Dow Jones Industrial average declining by over 1,100 points on February 5th. If this sort of thing continues, don't panic. Look at it as an opportunity to buy great companies while their prices are down. The best companies don't often sell at reasonable prices during a bull market, so a little volatility can be your best chance to upgrade the quality of your portfolio.
- Shorten bond duration. Ten-year Treasury bond yields recently soared to 2.75 percent, roughly double the low point they reached in July of 2016. This sharp rise is indicative of the trend in interest rates ranging from short-term Fed Funds rates to 30-year mortgages. Rising interest rates mean declining bond prices, and the impact is especially acute on long-term bonds. With inflation apparently gathering strength, interest rates may not be done rising. Rebalancing your portfolio to a shorter bond duration can be one way to cushion the impact.
Portfolio rebalancing techniques for different age groups
Rebalancing does not necessarily mean resetting your portfolio to its original proportions. It is also an opportunity to reevaluate your needs. This means different things to different investors:
- Investors in their 20s and 30s may shift some investments around, but overall should remain heavily oriented towards growth investments. If market volatility becomes more severe, it might even be an opportunity to increase the stock allocation at more attractive prices.
- Investors in their 40s and early 50s should still be in growth mode, but should be especially cautious to make sure that growth in stock prices has not left them more exposed to equities than they intended. They should remain alert to new stock opportunities, but more as replacements for existing holdings rather than additions to their equity allocation.
- Investors approaching retirement age should look at rebalancing as an opportunity to harvest some gains and gradually downshift to a more conservative allocation. This should help make sure money is available when you need to draw on it.
Again, rebalancing can normally be thought of as routine maintenance, but today's conditions make it more urgent. The good news is that exceptional market returns in recent years put you in a position to rebalance from a position of strength, which is far better than picking up the pieces after an investment setback.