EagleTribune.com, North Andover, MA

December 22, 2013

Rebalance portfolio to control risk

Financially Speaking
John Spoto

---- — It’s been a very good year for stock investors. The Standard & Poor’s 500 Index, which serves as a proxy for the U.S. equity market , is up over 25 percent in the last 12 months and stands close to an all-time high. For those who began the year with a well-conceived investment mix of stocks, bonds and cash that matched both their goals and their ability to handle risk, it’s now likely that portfolio is out of whack and substantially more risky.

Asset allocation, the proportion of total assets that an investor devotes to stocks, bonds and cash is far and away the most important part of designing a successful portfolio. More than any other factor, it will determine the returns investors earn and the level of volatility they experience. In general, the higher the allocation to stocks the more subject the portfolio is to the wild swings of the equity markets.

While assembling the right mix of investments is important so is maintaining it. Stocks and bonds react differently to market conditions and, therefore, behave differently throughout the year. Over time, the higher-performing assets (typically stocks) will grow to occupy a larger portion of the portfolio. The result is a portfolio that may be markedly different and more risky from what the investor originally intended.

Rebalancing the portfolio back to its original target allocation is an important risk-control measure that will reduce its volatility over time and may very well serve as the anchor needed to stop investors from abandoning their investment plan in a panic during the next steep market decline. In the simplest terms, rebalancing means taking profits from those asset classes that have performed well and reinvesting the proceeds in those that have performed poorly. Here are some things to keep in mind:

— Rebalancing isn’t free. The process can trigger capital gains taxes and incur transaction costs. The most cost-effective strategy for rebalancing is highly dependent upon an investor’s individual circumstances, including the weighting of different assets held in taxable, tax-deferred and tax-free accounts.

— Rebalancing isn’t easy. Selling winners and buying losers takes discipline and grit. Humans are emotional beings, so don’t underestimate the difficulty of selling stocks when the market is soaring and buying what is arguably the most unloved asset class, bonds. This is especially true in light of the expectations of future interest rate increases, which have a negative effect on bond values.

Everyone believes they can stomach lots of risk in a rising market. According to Fran Kinniry of Vanguard Investment Strategy Group, “We are now seeing for the first time since the onset of the global financial crisis significant positive cash flows into stock funds and negative flows out of bond funds. Investors tend to flee stocks during downturns and become enamored with them again after upswings.”

Rebalancing isn’t an attempt to predict the future. The goal isn’t to maximize returns by pouring money into investments that we “think” will outperform the others. Not even the smartest minds in finance can predict the short-term direction of the financial markets. Rather than maximizing returns, the objective of rebalancing is to control risk.

Be prepared, you may feel dumb at first as you see the investments you just sold continue to climb for a while. But you’ll be looking pretty smart and, more importantly, sleeping well when the market experiences its next crisis.

John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com .

This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.