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Balanced Investing for Balanced Living

In the market’s never-ending story, we never know how its most recent action will play out. One thing we do know is that when the market is more volatile than usual, investors who lack a personalized, long-term plan to guide their way are far more likely to make the wrong moves by the time the cycle is complete. In our opinion, every investor’s long-term plan should include embracing a buy, hold and rebalance approach to investing. This is one of the simplest and most effective ways to diversify and it may help you prosper in various financial markets over the long-term.

To achieve this goal, a portfolio is initially allocated based on each investor’s needs across different asset classes such as stocks, bonds and real estate. The portfolio mix is then maintained by periodically rebalancing. Winning investments are pared back and underperforming investments are increased during a rebalancing. A rebalancing can occur on a specific date, such as a birthday or anniversary, or it can be done using a percentage of asset method. See my book, All About Asset Allocation for a detailed discussion of rebalancing techniques.

Figure 1 is an illustration of rebalancing using a 50% stock and 50% bond allocation. When stocks gain versus bonds, their percentage or allocation becomes too large. Shares of the stock investment are sold and the proceeds are reallocated to bonds. This serves as a risk control mechanism for the portfolio.

Another effective way to rebalance is to employ new dollars when they are available. For example, if you were to receive a modest lump sum of cash, you could use it to “feed” the portion of your portfolio that requires additional assets. If you were underweighted in bonds, for example, you could apply the new dollars there. This helps you rebalance while minimizing the transaction costs involved.

Figure 1: Rebalancing a 50% stock and 50% bond portfolio

Chart by R.Ferri.

Some financial pundits criticize a balanced approach. They say a buy, hold and rebalance strategy is simple-minded and a relic of the past. Often, their solution is to be tactical, meaning they suggest that investors aggressively move in and out of the markets in an attempt to avoid the worst returns and capture the best ones. As it turns out, the data suggests that more than half the experts fail to time markets correctly; their portfolios are expected to fall short of the simple strategy they mock so much.

Consider Figure 2, which illustrates the returns of a portfolio initially allocated to 50 percent in stocks and 50 percent in bonds from January 1, 2007 through August 31, 2015. The period begins just prior to the worst bear market in recent memory, and includes a surge in stock prices that occurred in the years thereafter. The proxy for stocks was the CRSP Total Stock Market Index and the proxy for bonds was the Barclays Capital US Aggregate Bond Index. Both indexes hold broad representations in their respective markets. The 50/50 portfolio was rebalanced monthly; annual rebalancing works just as well.

Figure 2: Comparing a 50/50 Bond/Stock Portfolio to Each Index

Source: CRSP and Barclays Capital data from DFA Returns Program, chart by R. Ferri.  

At least on paper, every stock investor lost portfolio value during the crushing bear market that began in October 2007. Prices were down nearly 60 percent from peak to trough. A 50 percent stock and 50 percent bond portfolio was down about 20 percent from the peak. Even a portfolio holding only 20 percent in stocks didn’t escape the bear and was down about 5 percent by the time the market hit bottom in March 2009.

Still, Figure 2 shows that the 50/50 diversified, rebalanced portfolio fared quite well during the bear market and the recovery that followed. The return hasn’t matched a 100 percent stock portfolio over the entire period, but the volatility was considerably lower – and volatility matters! 

Investors who assume the party will never end and take on too much equity risk when markets are surging upward over extended periods run the risk of capitulating in the next bear market. They often lack a disciplined plan to see their way through, and may never fully recover the realized losses they incur after selling. Lower volatility created by a disciplined allocation to stocks and bonds helps keep you invested during all market conditions.

Ideally, our crystal ball could tell us to get out of stocks before the crisis, but realistically no one knows what the market is going to do in the future. We invest in stocks because in the long-term the returns are expected to be substantially better than bonds. We need this growth just to stay ahead of inflation and taxes. Patience is a virtue, though. Bear markets occur without warning; bull markets often follow on their heels with equal unpredictability. And so on, and so forth. Only those with discipline throughout can expect to build wealth according to a rational course, rather than depending on random and very fickle fortune to be their “guide.”

Balanced investing is part of balanced living. A buy, hold and rebalance strategy using broad market index funds is one of the simplest and most effective ways to diversify and prosper over the long term. It helps keep us sane and our portfolios more reliably on track during good times and bad.