This is the only investment “rule” you really need to get richer


With stock indices way up for the year, including the Dow Jones Industrial Average — which topped 23,000 in mid-October 18 and seems to be chugging along toward 24,000 — it may seem like there’s no end in sight for this historic bull market. But despite record stock price highs, investors have been quietly withdrawing money from stock investments throughout 2017.

While it may seem counterintuitive to sell stocks when they’re on a roll, smart money could be onto something. While some people may be cashing out, others appear to be shifting assets into bonds — in part to reduce the risk that a stock market crash will wipe out gains for the year.

That move is an example of “rebalancing,” a central tenet of most long-term investing strategies. Whether your only investments are in a retirement account (like a 401(k) or IRA) or not, rebalancing is a helpful tool to reach goals: like that $1 million target for old age that experts suggest as a minimum.

The idea of rebalancing is to first set a goal based on tolerance for risk — which affects how much money you want in stocks versus bonds. A more aggressive portfolio might have 90% stocks and 10% bonds, while a more conservative one could have 60% stocks and 40% bonds, for example. Then you periodically check in on your portfolio to see how close your investments in the different asset categories have hewed to those ideal percentages.

Since stocks tend to increase in value faster than bonds, chances are you will already have a higher percentage of money in equities in 2017 than you originally intended, if you’ve never rebalanced before — and your funds don’t automatically rebalance for you. You’ll need to decide whether to rebalance back to your original percentages or shift strategies.

While there are loose guidelines for how to balance your portfolio at any age, generally speaking you want more in stocks when you are just starting your career and less as you approach retirement. But in the end, it’s a personal choice. “Everyone has to decide for themselves,” Colleen Jaconetti, a senior investment strategist at Vanguard, said in a phone interview.

To figure out if rebalancing makes sense for you, here’s a guide to how it works, why people do it and how to find an approach that works best.

Why should I rebalance, exactly?

“You rebalance to control risk, not necessarily to increase return,” William Bernstein, a financial theorist, neurologist and author of The Four Pillars of Investing, said in an email interview.

Sure, if you want to get the highest returns on your money over the long run, you would probably just invest 100% of your cash in stocks as opposed to bonds. But the trouble with putting all your money in stocks is that equity prices fluctuate much more than bond returns — they have historically gone up as much as 54% and down as much as 44% in a single year — making for a financial rollercoaster most investors can’t stomach. After all, if skittishness drives you out of the market at the wrong time, you could end up losing way more money than if you had just had a better balance to begin with.

As you can see from the chart below, bond-only portfolios have had an annualized return of just 5.4% since 1926 — versus 9.7% for stock-only ones. Yet stock investors had to endure much wider swings in prices in any given year in exchange for those higher returns.


The hope is that with rebalancing, you stick to a mix that’s aggressive enough to grow your wealth — without exposing you to losses that will derail your plan: “If someone has a 100% stock portfolio, and the market drops 40%, they end up getting out of the market,” Jaconetti said. “If you react by getting out... you could have less money in your portfolio.”

That’s exactly what some people did in 2008, when the stock market abruptly sank 37%. In a single week during the peak of the financial crisis in October 2008, investors pulled $43.3 billion out of stock mutual funds. The sad fact, though, is anyone who went to cash in 2008 likely missed the opportunity to get back their losses during the market’s double digit rebound in 2009.

How does rebalancing work?

To give an example of how rebalancing can work in your favor, consider a $100,000 portfolio of 60% stocks and 40% bonds starting in 1997.

If you rebalanced every year to maintain those allocations, you would have wound up with $377,510 by the end of 2016. If, on the other hand, you never rebalanced, you would have ended up with $28,490 less, as you can see from the chart below:

T. Rowe Price/T. Rowe Price

It is relatively rare that rebalancing will increase your overall returns in any given year. But “how well you do in the long run depends disproportionately on how well you stay the course during the rare, very severe bear markets,” Bernstein added. “Investing is an operation that transfers wealth to those who have a strategy and can execute it from those who do not or cannot.”

How much risk are you willing to take?

Before you start rebalancing, you need to have some money stashed away. For most millennials, that will likely be in the form of a retirement account such as a 401(k) or IRA. One of the first questions to ask yourself when you are setting one up or trying to rebalance existing funds is how much money you want to put in stocks versus bonds.

If you have a target-date fund, your financial company will make that decision for you, based on your estimated retirement date. If you’re in your 20s or 30s, an allocation of anywhere from 70% to 90% in stocks is fairly typical. As you get closer to retirement, the percentage of your portfolio in stocks will likely shrink to between 40% and 60%, Jaconetti said.

If you decide to take matters into your own hands, figuring out the right mix of stocks and bonds mostly boils down to your risk tolerance. That means you need to gauge the point at which the pain of a big loss is greater than the pleasure you would get from an equally big gain.

Here are some key questions to ask yourself, from the Financial Samurai blog:

What is my risk tolerance on a scale of 0-10?
If my portfolio dropped 50% in one year, will I be financially okay?
How stable is my primary income source?

You can also take an online quiz from Vanguard and Rutgers, which ask questions like whether you agree or disagree with statements like, “I prefer investments with little or no fluctuation in value” and “During market declines, I tend to sell portions of my riskier assets and invest the money in safer assets.”

The one drawback with these quizzes is that they present hypothetical situations, when in reality, “there’s only one way to truly calibrate your risk tolerance, and that’s to have it tested,” Bernstein said. You won’t really know what you’ll do in a market downturn, for example, until you experience the pain of watching your net worth sink 30%. (From personal experience — it hurts.)

What’s more, the way you feel now could be misleading: “People are naturally more aggressive when the market is higher, but when it corrected in 2008 that is when they get scared,” said certified financial planner Bill Van Sant, managing director at Univest Wealth Management.

To get around this problem, Bernstein suggested using the act of periodic rebalancing to figure out what your true risk tolerance is. “For example, if you’re 60/40 [stocks/bonds] and rebalancing back to that feels awful during a severe bear market, then 60/40 is too aggressive. On the other hand, if you can do it without a second thought, then you might consider increasing your equity policy,” he said.

How do I rebalance my retirement account?

The best way to rebalance is a subject of hot debate, with the primary options being either at a fixed-time interval (like annually or semiannually) or when your investments veer from your targets by a certain threshold (such as 5% or 10%).

Vanguard recommends a combination of both strategies, in order to avoid what’s known as “portfolio drift,” which is what happens when your assets shift away from your ideal target allocations.

For lazier folks, there’s another option: An alternate time-based approach involves waiting up to three years before you rebalance in order to best take advantage of the market’s cycles of momentum and reversion.

As Bernstein explained, “asset classes exhibit positive returns autocorrelation (i.e., momentum) even at one year. At 2-3 years, that turns negative (mean reversion). Empirically, for the same reason, it seems to work better at that longer horizon.”

In a year like 2017, when stocks are up, it may feel hard to sell your winners in the name of rebalancing. “Emotionally people have trouble selling what’s doing well,” said Fidelity Vice President and Fort Lauderdale branch manager Wendy Liebowitz. One way to avoid selling your top investments is to rebalance by directing only new contributions and dividends into bonds, rather than taking money out of stocks.

In the end, the best rebalancing strategy, just like the best exercise program or diet, is one you can actually stick to.

For most people, that means moderation, and a tactic requiring the least amount of time that still puts you the most at ease, by balancing high enough returns with a level of risk that lets you sleep at night.

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