Category Archives: rebalancing investment portfolio

Bonds Have Risks Other Than Rising Interest Rates. Dividend Stocks are not Substitutes for Bonds.

24 Sunday Jul 2016

Posted by in academics, asset allocation, bond basics, bond market, Bond Mathematics, Bond Risks, bonds, Fabozzi, finance, finance theory, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, financial planning, financial services industry, Fixed Income Mathematics, foreign currency, Frank Fabozzi, Individual Investing, individual investors, interest rates, investing, investing advice, investing information, investing tips, investment advice, investments, math, MBS, personal finance, rebalancing, rebalancing investment portfolio, rising interest rate environment, rising interest rates, risk, risks of bonds, Search for Yield, statistics, types of bonds, volatility, yield

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The main reason why Financial Advisors are recommending that individual investors sell bonds is that interest rates are likely to rise over the next 3-5 years or more.  Although those sentiments have been a familiar refrain over the last 3-5 years though.  Well, I would tend to agree that interest rates are poised to rise at some point toward the end of this decade.  However, interest rate risk is only one of the risks of bonds.  In fact, the size of the bond market dwarfs the stock market.  When Financial Advisors are talking about bonds, they tend to be referring only to US Treasury bonds, corporate bonds, and municipal bonds.  Interest rate risk greatly affects these bonds indeed.  With that being said, they tend to conflate the interest rate risk of these bonds with the entire bond market.  Remember that interest rates have dropped from 16.30% on the 1-month US Treasury bill back in 1981 to roughly 0.25% today.  Therefore, bond prices have been rising for over 35 years and most financial professionals outside of the fixed income markets have forgotten (or if they are younger than 50) how bonds normally work, especially in a rising interest rate environment.

But does it even matter really? Yes.  Here is an urgent note to all individual investors:  “Beware of financial professionals that recommend dividend stocks or other equities as replacements for your fixed income allocation”.  What I mean by this is that the volatility of stocks is far greater than bonds historically.  Yields may be very low in money market funds, US Treasuries, and in bond mutual funds now.  However, your risk tolerance must be taken into account at all times.  While it is true that many dividend-paying stocks offer yields of 3% or more with the possibility of capital appreciation, there also is significant downside risk.  For example, as most people are aware, the S&P 500 index (which represents most of the biggest companies in America) was down over 35% in 2008.  Many of those stocks are included in the push to have individual investors buy dividend payers.  With that being said, stock market declines of 10%-20% in a single quarter are not that uncommon.  If you handle the volatility of the stock market well, there is no need to be concerned.  However, a decline of 10% for a stock paying a 3% dividend will wipe out a little more than 3 years of yield.  Individual investors need to realize that swapping traditional bonds or bond mutual funds is not a “riskless” transaction, meaning a one-for-one swap.  The volatility and riskiness of your portfolio will go up commensurately with your added exposure to equities.  Sometimes financial professionals portray the search for yield by jumping into stocks as the only option given the low interest rate environment.

While your situation might warrant that movement in your portfolio allocation, you need to be able to accept that the value of those stocks is likely to drop by 10% or more in the future just taking into account normal volatility in the stock market historically (every 36 months or so in any given quarter).  Are you able to handle that volatility when looking at your risk tolerance, financial goals, and age?The purpose of this blog post is to discuss the risk factors associated with bonds in greater detail.  Most bonds, such as Treasury notes and bonds, corporate bonds, and municipal bonds, will go down in value when interest rates go up.  Conversely, they will go up in value when interest rates decrease.  This characteristic of these types of bonds is called an inverse relationship.  For a primer on how most bonds function normally, I have posted supplementary material alongside this post.  You can refer to it to brush back up on bonds and how they work, and I also provide a historical look at interest rates over the last 35 years.  Here is the link to that prior blog post:https://latticeworkwealth.com/2014/01/02/a-bond-is-a-bond-is-a-bond-right-should-you-sell-bonds-to-buy-stocks-supplementary-information-on-how-bonds-work/

There are many risk factors associated with investments in bonds.  A great overview of those risks can be found in Fixed Income Mathematics the Fourth Edition by Dr. Frank Fabozzi who teaches at Yale University’s School of Management.  Most fixed income traders, portfolio managers, and risk managers use his Handbook of Fixed Income Securities as their general guidebook for approaching dealing with the trading, investing, and portfolio/risk management of owning fixed income securities.  Suffice it to say that he is regarded as one of the experts when it comes to the bond markets.  Dr. Fabozzi summarizes the risks inherent in bonds on page 109 of the first text referenced above.  The risks are as follows:

  • Interest-rate risk;
  • Credit risk;
  • Liquidity risk;
  • Call or prepayment risk;
  • Exchange-rate risk.

Most of fixed income folks and myself would add inflation risk, basis risk, and separate credit risk into two components.  Bonds have two types of risk as it relates to payment of principal and interest.  The first risk is more commonly thought of and referred to as default risk.  Default risk is simply whether or not the company will pay you back in full and with timely interest payments.  Credit risk also can be thought of as the financial strength of the company.  If a company starts to see a reduction in profits, much higher expenses, and drains of cash, the rating agencies may downgrade their debt.  A downgrade just means that the company is less likely to pay back the bondholder.Here is an example to illustrate the difference more fully:  a company may have a AA+ rating from Standard & Poor’s at the beginning of the year, but, due to events that transpire during the year, the company may get downgraded to A- with a Negative Outlook.  Now the company is still very likely to pay back principal and interest on the bonds, but the probability of default has gone up.  As a point of reference, AAA is the highest and BBB- is the lowest Standard & Poor’s ratings to be considered investment grade.  You will note that the hypothetical company would need to be downgraded four more times (BBB+, BBB, BBB- to BB+) to be considered non-investment grade or a “junk” bond.   Bond market participants though will react to the downgrade though because new potential buyers see more risk of default given the same coupon.  So even though the company may not default eventually on the actual bond, the price of the bond goes up to compensate for the interest rate required by the marketplace on similarly rated bonds to attract buyers.Now I will address the full list of risks affecting bonds outlined by Dr. Fabozzi above.  Any bond is simply an agreement between two parties in which one party agrees to pay back money to the other party at a later date with interest.

All bonds have what is referred to as credit (default portion) risk.  Credit risk in general is simply the risk one runs that the party who owes you the money will not pay you back (i.e. default).  What is lesser known or thought about by individual investors is interest-rate risk and inflation risk.  These two risks are usually missed because investors tend to think that bonds are “safe”.  Interest-rate risk relates to the fact that interest rates may rise, while you hold the bonds (spoken about at length in the beginning of this blog post).  When financial pundits make blanket statements about selling bonds, they are referring to this one risk factor normally.  Inflation risk means that inflation may increase to a level higher than your interest rate on the bond.  Thus, if the interest rate on your bond is less than inflation or closer to inflation from when you bought the bond, your purchasing power goes down.  The prices of goods and services go up faster than the interest you earn on the bond.  Call risk refers to instances where some companies have the option to redeem your bonds in the future at an agreed upon price.  This is normally done only when interest rates fall. Prepayment risk is a more specialized case of call risk and refers to people paying their mortgages (or credit cards, home equity loans, student loans, etc.) back sooner than expected.  Most people group these two risks into a category called reinvestment risk.  Think about the concept in this manner:  many people refinanced their mortgages because interest rates went down.  They did so because they could lower their total mortgage payment.  Well, companies do the same thing if they have the option.  Companies can redeem bonds at higher interests and issue new bonds at lower interest rates.  Chances are that, if you are the owner of the redeemed bonds, you will be unable to find as high of an interest payment currently if you want to buy a bond with similar characteristics of the company issuing the bonds you own before.The other three risks I mentioned above are less commonly discussed and not quite as important.

Exchange-rate risk exists because sometimes a company issues bonds in a currency other than its own.  For example, you will sometimes hear the terms Yankee bonds or Samurai bonds.  Since the company is paying you interest and principal in a foreign currency that money may be worth more or less depending on what happens in foreign exchange markets in the future.

Liquidity risk refers to the phenomenon that there are certain crisis times in the market where very few, if any bond market participants, are willing to buy the bonds you are trying to sell.  Therefore, you might have to take a bigger loss in order to entice someone to buy the bonds given the current macro environment.

Basis risk is a more obtuse type of risk that institutions deal with.  Basis risk essentially refers to anytime when interest rates on your bond are pegged to another interest rate that is different but normally behaves in a certain way (referred to as correlation).  Now most of the time, the behavior will follow the historical pattern.  However, during times of stress like a liquidity and/or credit crisis, the correlations tend to break down.  Meaning you can think you are “hedged” but, if the historical relationship does not hold up, your end return will be nothing like what you had expected.  These two risks are not something that individual investors need to focus on for the most part, since these types of bonds are not normally owned by them.I will admit that this list is quite lengthy and, quite possibly, a bit too detailed and/or complicated.  However, I wanted to lay them all out for you.  Why?  When you hear Financial Advisors recommend that you sell a large portion of your bonds, and/or hear the same investment advice from the financial media, they normally are really only referring to interest-rate risk primarily and secondarily inflation risk as well.  As you can see from the description above, the bond market is far more complex than that to make a blanket statement.Now, as I usually say, I would never advise individual investors to take a certain course of action in terms of selecting specific bonds or not selling bonds to move into more stocks.  However, I am saying that you should feel comfortable enough to ask your Financial Advisor why he/she recommends that you sell a portion of your bonds.  If the answer relates only to interest-rate risk, I would probe the recommendation further.  You can explain that you know that is the case for Treasury notes/bonds, municipal bonds, and corporate bonds.  However, there are a whole host of other fixed income securities with different characteristics and risks.  Now I am not referring solely to Mortgage Backed Securities (MBS), although the residential and commercial markets for these are in the trillions of dollars.  There are bonds and notes that have floating interest rates which means that as interest rates go up, the interest rate you receive on that security goes up.  Not to mention that different countries are experiencing different interest rate cycles than the US (stable or downward even).The complete list is too in-depth to cover in a single blog post.  My goal was to provide you with enough information to at least ask the question(s).  Your risk tolerance and financial goals might make a move from bonds to stocks the best course of action.  With that being said, you also have the option of selling bonds and keeping the money in cash or investing in the different types of bonds offered in the fixed income markets while keeping your total allocation to fixed income nearly the same.  Thinking holistically about your portfolio, you may be increasing the riskiness of your portfolio beyond your risk tolerance or more than you are aware unbeknownst to you by moving from bonds into stocks.  This is something you definitely want to avoid.    It can turn out to be a rude awakening and hard lesson to learn one or two years from now.

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Four Important Lessons for Individual Investors from the Brexit Vote

10 Sunday Jul 2016

Posted by in Alan Greenspan, Black Swan, bond market, Brexit, Brexit Vote, Emotional Intelligence, EQ, EU, European Union, Fed, Federal Reserve, finance, finance theory, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Greenspan, Individual Investing, individual investors, Internet Bubble, investing, investing advice, investing information, investing tips, investment advice, investments, Irrational Exuberance, Nassim Taleb, personal finance, portfolio, Post Brexit, PostBrexit, rebalancing, rebalancing investment portfolio, risk, risk tolerance, stock market, Stock Market Returns, Stock Market Valuation, Taleb, Uncategorized, Valuation, volatility, Warren Buffett

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The vote by the United Kingdom (UK) to leave the European Union (EU) caught the majority of individual investors by surprise.  In fact, the so-called Brexit was not foreseen by many of the most sophisticated professional investors and money managers all around the world.  The election results sent shockwaves through the financial markets on the Friday and Monday following the Brexit vote.  The most notable effect was the devaluation of the pound to its lowest level since 1985.  Over the course of Tuesday through Friday, the US and European stock markets gained back nearly all their losses from the two days after the Brexit vote.  This fast-moving volatility has left individual investors feeling confused, frustrated, bewildered, and a bit scared.  However, the Brexit vote results offer individual investors a unique set of key lessons to learn and understand.

The four important lessons for individual investors from the Brexit vote are as follows:

  • 1)  There are very few seminal events in financial market history that affect the future path of stocks, bonds, and other assets.

 

The difficult thing to realize about the financial markets is that there are very few consequential events that make an inflection point or major change in the direction of the financial markets.  Even more frustrating than that, these consequential events are only known with the benefit of hindsight.  In other words, what seems like a monumental event today may or may not be considered one of those major events.  Given the fact that there are so few, there is a high probability that the seemingly major events of today will not fall into the seminal event category of financial market history.

What are some of the seminal events in financial market history?  Here is a list of some of the seminal events in chronological order:  the stock market crash in October 1987, the bursting of the bond bubble in 1994, the Asian contagion of 1997-1998, the bursting of the Internet bubble in March 2000, and the Great Recession of the financial crisis starting in September 2008.  There are many more examples previous to 1987, but these are events from recent financial market history that many individual investors will remember.  Keep in mind that in between all of these events are a string of other major events that turned out to be minor blips that caused only fleeting financial market volatility or none at all.

Furthermore, these seminal events are confusing to financial market participants in and of themselves.  For example, let’s take a closer look at the stock market crash of October 1987.  The US stock market dropped over 20% in one day, and things looked very dire.  If an individual investor with a portfolio of $100,000 had sold his/her stock mutual funds (primary investment vehicle used by individuals on the day of the crash, he/she would have a portfolio worth $80,000 approximately.  That type of individual investor was likely to be very fearful and stay out the of stock market for the remainder of 1987.  If an individual investor with a similar portfolio of $100,000 had keep his/her money in stocks on the day of the crash and for the rest of 1987, he/she would actually have roughly $102,000 at the end of 1987.  Why?  Well, there are not too many investors these days that remember how 1987 really turned out for the US stock market.  The S&P 500 index ended up about 2% for the year, so US stocks recovered all of the losses from the crash and a bit more.  Here’s a little fun exercise:  Ask your Financial Advisor or Financial Planner what the return of stocks was in 1987.  The vast majority will assume it was a horrible down year for performance returns.

Another excellent example is the bursting of the Internet bubble in March 2000.  The reason it is so interesting is that individual (and even professional) investors forget the history.  Alan Greenspan, the Chairman of the Federal Reserve during that time period, gave a famous speech where he coined the term, “irrational exuberance”.  Greenspan warned investors that the Internet and technology stocks were getting to valuations that were way out of line with historical norms for valuation of stocks.  What do individual investors forget?  Well, that famous speech was actually given in December 1996.  Yes, that is correct.  Greenspan warned of the Internet bubble, but it took nearly 3 ½ years before financial markets took a nosedive.  The main point here is that smart, rationale professional money managers and economists can know that financial market valuations are out of whack in terms of valuation at any given point in time.  (Note that this can also be stock market valuations that are too low).  However, these conditions can persist for far longer than anyone can imagine.  That is why individual investors should not be so quick to sell (or buy) major portions of their portfolio of stocks and bonds when these predictions or observations are make.

For a more in depth look at this concept, you can refer to a blog post I wrote three years ago on this very subject.  The link to that blog post is as follows:

https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/

  • 2)  Investors focus on valuations (no emotions) while traders and speculators focus on market sentiment (emotions) and valuation (no emotions).

The majority of professionals who talk to individual investors and provide advice will explain how important it is to keep emotions out of the equation when dealing with elevated market volatility.  When the financial markets are bouncing up and down by large amounts in the short term, it can be very difficult to keep a cool head and resist the urge to buy or sell stocks, bonds, or other assets.  The frenetic pace of market movements makes it seems as though an individual investor needs to do something, anything in response.  The standard advice is to keep one’s emotions in check focus on the long term, and stick to the financial plan.  What is usually missing from that advice is a more complete explanation why.

There are two general types of financial market participants:  investors and traders/speculators.  These two groups have vastly different goals and approaches to the financial markets.  Investors are focused on investing in stocks, bonds, and other assets in order to obtain returns over time from their investments.  The long term might be defined as five years.  Thus, day-to-day fluctuations in the financial markets mean very little to them.  On the flipside, traders/speculators are focused on making gains in stocks, bonds, and other assets in the short term in order to obtain returns.  The short term for this group might be hourly, the medium term might be daily, and the long term might be weekly.  With this particular group, they need to determine both the likely direction of the financial markets due to both market sentiment and valuation.

As you might imagine, the traders/speculators have to analyze emotions or the psychology of financial market participants.  Gauging market sentiment (general short term positioning of traders/speculators in stocks, bonds, and other assets in terms of their trend to buy or sell) is all about emotions.  Additionally, they must be able to combine that with proper valuations for stocks, bonds, and other assets.  Essentially they need to be correct twice.  On the other hand, investors are focused on the long term which corresponds to valuation.  Valuation over the long term is not driven by emotions.  There is a very famous saying by Ben Graham who taught one of the most well-known investors of all time, Warren Buffett.  Graham said, “In the short term the market is a voting machine, in the long term the market is a weighing machine.”  The takeaway from Graham’s quotation is that market sentiment (i.e. emotions) can drive the financial markets wildly over the short term.  However, after a period of years, financial markets always seem to follow the path back to what their true valuations are.  Since emotions are not part of that equation, individual investors should feel more comfortable ignoring or at least subduing their emotions whenever the financial markets exhibit high levels of volatility.

A related part of the story is the financial media (both TV and print) almost always provide information for traders/speculators.  To be perfectly honest, the financial media would not have much to talk about if long-term investing was the topic.  Essentially they would recommend analyzing one’s risk tolerance, define one’s financial goals, and then build a portfolio of financial assets to reach those goals over the long term.  Yes, true investing is very boring actually.  The financial media needs to have something more “exciting” to talk about in order to have viewers (readers) and the corresponding advertising dollars that come from that.  Therefore, the stories and article appearing in the financial media are geared toward traders/speculators.  Now if you are an investor, you can either ignore this bombardment of information or take it with the proverbial “grain of salt”.  Thus, you can keep your emotions in check when all the traders/speculators are wondering how to react to the market volatility right now each and every trading day or week.

For a more in depth discussion of managing one’s emotions as it relates to investors, you can refer to one of my older blog posts.  The link to that blog post is as follows:

https://latticeworkwealth.com/2015/06/11/two-steps-to-help-individual-investors-become-more-successful-at-investing/

  • 3)  The benefit of diversification can disappear or be reduced greatly whenever there are periods are elevated volatility.

The benefit of diversification is one of the hallmarks of the proper construction of an investment portfolio for individual investors.  The basic premise (which has been proven over very long periods of time) is that investing in different asset classes (e.g. stocks, bonds, real estate, precious metals, etc.) reduces the volatility in the value of an investment portfolio.  A closer look at diversification is necessary before relating the discussion back to the Brexit vote.  The benefit of diversification stems from correlations between asset classes.  What is correlation?  To keep things simple, a correlation of 1 means that two different assets are perfectly correlated.  So a correlation of 1 means that when one asset goes up, the other asset goes up too.  A correlation of -1 means that two assets are negatively correlated.  So a correlation of -1 means that when one asset goes up, the other asset goes down (exactly the opposite).  A correlation of 0 means that the two assets are not correlated at all.  So a correlation of 0 means that when one asset goes up, the other asset might go up, go down, or stay the same.  Having an investment portfolio that is properly diversified means that the investments in that portfolio have a combination of assets that have an array of correlations which dampens volatility.  Essentially the positively correlated assets can be balanced out by the negatively correlated assets over time which reduces the volatility of the balance in one’s brokerage statement or 401(k) plan.

What does all this correlation stuff have to do with the Brexit vote?  Surprisingly, it has quite a bit to do with the Brexit vote.  Note that this discussion also applies to any situation/event that causes the financial markets to exhibit high levels of volatility.  During extreme volatility like investors witnessed after the Brexit vote, the correlations of most asset classes started to increase to 1.  Unfortunately for individual investors, that meant that diversification broke down in the short term.  Most all domestic and international stock markets went down dramatically over the course of the two trading days following the Brexit vote.  Therefore, individuals who had their stock investments allocated to various different domestic and international stocks or value and growth stocks all lost money.  When correlations converge upon 1 during extreme market shocks, there is really nowhere to “hide” over the short term.  In fact, the only two asset classes that did very well during this period were gold and government bonds.

What is the key takeaway for individual investors?  Individual investors need to realize that there is an enormous benefit to having a diversified portfolio.  However, diversification is associated with investing over the long term and thereby harnessing its benefit.  There are times of market stress, like the Brexit vote and aftermath, where diversification will not be present or helpful.  When those times come around, individual investors need to keep emotions out of the picture and stick to their long-term financial plans and investment portfolios.

  • 4)  The surprise Brexit vote provides the perfect opportunity for individual investors to evaluate their risk tolerances for exposure to various risky assets.

The two trading days after the surprise vote by the UK to leave the EU (Brexit) were very volatile and very tough to keep emotionally calm.  Individual investors were faced with a very unusual situation, and the urge to sell many, if not all of their investments was very real.  That reaction is perfectly understandable.  Now for the bad news, there will be another time when volatility is as great as or larger than the volatility that the Brexit vote just caused.  In fact, there will be many such periods over the coming years and decades for individual investors.  In spite of that bad news, the Brexit vote should be looked at as a learning experience and opportunity.  Since individual investors know that there will be another period of elevated volatility, they can revisit their personal risk tolerances.

It is extremely difficult to try to determine or capture one’s risk tolerance for downturns in the financial markets in the abstract or through hypothetical situations.  You or with the assistance of your financial professional normally asks the question of whether or not you would likely sell all of your stocks if the market went down 10%, 15%, 20%, or more.  How does an individual investor answer that question?  What is the right answer?  There is no right or wrong answer to that type of question.  Each individual investor is unique and has his/her own risk tolerance for fluctuations in his/her investment portfolio.  A better way to answer the question is to convert those percentages to actual dollar amounts.  For example, if an individual investor starts with $100,000, would he/she be okay with the investment portfolio decreasing to $90,000, $85,000, or $80,000 over the short term.  Note that the aforementioned dollar amounts sync up with the 10%, 15%, and 20% declines illustrated previously.

The opportunity from the Brexit vote is that individual investors have concrete examples of the volatility experienced in their investment portfolios.  It is far easier to analyze and determine one’s risk tolerance by looking at actual periods of market stress.  Depending on your stock investments, the total two-day losses might have been anywhere between 5% to 10%.  Let’s use a 10% decline for purposes of relating this actual volatility to one’s risk tolerance.  If an individual investor was invested 100% in stocks prior to the Brexit vote, he/she would have lost 10% in this scenario.  Let’s use hypothetical dollar amounts:  if the starting investment portfolio was $100,000, the ending investment portfolio was $90,000.  Now the vast majority of individuals do not have all of their money invested in stocks.  So let’s modify the example above to an individual investor who has 50% in stocks and 50% in cash.  In that particular scenario, the individual investor has $50,000 invested in stocks and $50,000 invested in cash.  If stocks go down by 10%, this individual investor will have an ending investment portfolio of $95,000.  Why?  The individual investor only losses 10% on $50,000 which is $5,000 not the full $10,000 loss experienced by the individual investor with a hypothetical portfolio of 100% in stocks.

The importance of the illustrations above and its relation to the Brexit vote is that one can quickly calculate the actual losses from a market decline with a good degree of accuracy.  So let’s say that you had 60% of your money invested in stocks prior to the Brexit vote.  If the overall stock market declines by 10%, your stock investments will only decline by 6% (60% * 10%) assuming the other 40% of your investment portfolio remained unchanged.  So let’s put this all together now.  If you look back at the stock market volatility caused by the Brexit vote, you need to adjust the overall stock market decline by the percentage amount you have invested in stocks.  That adjusted percentage loss will be close to the decline in your overall investment portfolio.  Now whatever that adjusted percentage amount is, ask yourself if you are comfortable with that percentage loss over the short term.  Or is that way too risky?  If the adjusted percentage is way too risky for you and makes you uncomfortable, that is perfectly fine.  The important piece of knowledge to learn is that you need to work with your financial professional or reexamine your investment portfolio yourself to reduce your exposure to stocks such that the adjusted percentage loss is reasonable for you to withstand.  Why?  Because there will be another market volatility event on the order of magnitude of the Brexit aftermath or even worse.

Keep in mind that I am not making a financial market prediction over the short term.  The important point is that the history of financial markets has shown that periods of elevated market volatility (i.e. lots of fluctuations up and down) keep occurring over time.  The Brexit vote provides a real-life example to determine if your risk tolerance is actually lower than you first imagined.  The next cause of market volatility may be a known market event similar to how the UK vote to leave the EU was.  The harder things to deal with are market volatility stemming from the unknown and unforeseeable.  These market volatility events are called “black swans” which is the term coined by Nassim Taleb in his book by the same name several years back.  A “black swan” can be a positive event for the market or a negative event for the market.  As it relates to individual investors and risk tolerance, the negative “black swan” is applicable.  Now the term “black swan” is improperly used today by many investment professionals.  A “black swan” is an event that by definition is unknown and cannot be predicted.  When it does occur though, there is a period of extreme market volatility afterward.  Thus, you can adjust your risk tolerance to be better prepared for future events that will cause market volatility, either known events like the Brexit vote or unforeseen events.  The Brexit vote aftermath should be embraced by individual investors as a golden opportunity to ensure that they are properly (or more precisely) measuring their risk tolerances.

Summary of Important Lessons for Individual Investor from the Brexit Vote:

  1.  There are very few monumental financial market events that should cause individual investors to feel inclined to immediately change their investment portfolios. Plus, they can only truly be identified by hindsight;
  2. Investors should focus on valuation of financial assets (no emotions here), traders/speculators worry about market sentiment (emotions) and valuation (no emotions here);
  3. The benefit of diversification can disappear or be greatly reduced during periods of extreme market volatility and financial market stress over the short term;
  4. The surprise Brexit vote offers individual investors a valuable opportunity to see if their risk tolerances are aligned with the possibilities of short-term market declines.  This real-life event can be used to redefine one’s risk tolerance to better withstand similar periods of market volatility that will inevitably occur in the future.

The Top 5 Most Read Articles in my Investing Blog During 2015

29 Tuesday Dec 2015

Posted by in asset allocation, bond market, bonds, Consumer Finance, Fed, Federal Reserve, finance, finance theory, financial advice, Financial Advisor, financial advisor fees, financial advisory fees, financial goals, financial markets, financial planning, financial services industry, Individual Investing, individual investors, interest rates, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, investments, passive investing, personal finance, portfolio, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, reasonable financial advisor fees, rebalancing, rebalancing investment portfolio, rising interest rate environment, rising interest rates, risk, risk tolerance, statistics, stock market, stock prices, stocks, Yellen

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The most popular articles read over the past year included some writings from a couple of years ago and were also on a myriad of topics. The listing of articles below represents the most frequent viewings working downward.

  1. Are Your Financial Advisor’s Fees Reasonable? Are You Actually Adding More Risk to Your Ability to Reach Your Long-Term Financial Goals? Here is a Unique Way to Look at What Clients Pay For.

 

This article has consistently drawn the most attention from readers of my investing blog. Individual investors have learned from me and many others that one of the most important components of being successful long-term investors is by keeping investment costs as low as possible.  This particular writing examines investing costs from a different perspective.  In general, the higher the investment costs an individual investor incurs, the higher the allocation to riskier investments he/she must have to reach his/her financial goals.

Link to the complete article: https://latticeworkwealth.com/2013/10/26/are-your-financial-advisors-fees-reasonable-are-you-actually-adding-more-risk-to-your-ability-to-reach-your-long-term-financial-goals-here-is-a-unique-way-to-look-at-what-clients-pay-for/

2. Are Your Financial Advisor’s Fees Reasonable? Here is a Unique Way to Look at What Clients Pay For.

 

This article is closely followed by the previous one in terms of popularity and forms the basis for that discussion actually. The general concept contained in this writing is that most asset managers now charge investors a fee for managing their investments based upon Assets under Management (AUM).  The fee is typically 1% but can be 2% or higher.  The investment costs to the individual investor per year are the total balance in his/her brokerage account multiplied by the fee which is commonly 1%.  However, the 1% grossly misrepresents the actual investment costs because the individual investor starts off with the total balance in his/her brokerage account.  The better way to express the fees charged per year is to divide the AUM percentage by the growth in the portfolio over the year.  That percentage answer will be quite a bit higher.

Link to the complete article: https://latticeworkwealth.com/2013/08/07/are-your-financial-advisors-fees-reasonable-here-is-a-unique-way-to-look-at-what-clients-pay-for/

3)  Rebalancing Your Investment Portfolio – Summary

 

Earlier in the year, I compiled a three-part series that examined the concept of rebalancing one’s investment portfolio. Rebalancing is an excellent investing strategy to learn about and apply at the end of the year.  Rebalancing in its simplest definition is the periodic reallocation of the investment percentages in one’s investment portfolio back to an original model after a passage of time.  This summary of rebalancing provides a look at rebalancing that is helpful for novice individual investors through more advanced folks.

Link to the complete article: https://latticeworkwealth.com/2015/11/25/rebalancing-your-investment-portfolio-summary/

4)  How to Create an Investment Portfolio and Properly Measure your Performance: Part 2 of 2

 

While this article is the second part of a discussion on the creation of an investment portfolio, it is arguably the more important of the two because it looks at a topic too often not relayed to individual investors. This writing talks about the importance of measuring the performance of your investment portfolio’s investment returns.  The financial media tends to focus solely on comparing your portfolio to the performance of the S&P 500 Index.  That comparison is “apples to oranges” the vast majority of the time because most individual investors have many different types of investments in their portfolios.  Therefore, I show you how institutional investors measure the performance of their investment portfolios.  The concept is broken down into smaller parts so it is very understandable and usable for individual investors.

Link to the complete article: https://latticeworkwealth.com/2013/07/19/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-2-of-2/

5)  How Can Investors Survive in a Rising Interest Rate Environment? – Updated

 

Although this particular article was first published a couple of years ago, the content is even more valuable today. The Federal Reserve increased the target range for the Federal Funds Rate by 0.25% on December 16, 2015 and has indicated that more interest rate increases are likely in the future.  Thus, we have entered a period in which interest rates are generally headed higher over the next several of years.  Most financial pundits will bemoan this type of environment because higher interest rates mean that the prices of most bonds go down.   It makes it harder to earn any investment returns from bonds.  However, there are a number of investments and investment strategies that benefit from an increasing interest rate environment.  This article examines six different things individual investors can do.

Link to the complete article: https://latticeworkwealth.com/2013/11/30/how-can-investors-survive-in-a-rising-interest-rate-environment-updated/

 

I hope you enjoy these popular articles from my investing blog. My goal is to keep on releasing more information in 2016 to assist individual investors in navigating the world of investing.  Thank you to all my readers in the United States and internationally!

Rebalancing Your Investment Portfolio – Summary

25 Wednesday Nov 2015

Posted by in asset allocation, bonds, Consumer Finance, Emotional Intelligence, finance, finance theory, financial advice, financial goals, financial markets, financial planning, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, personal finance, portfolio, rebalancing, rebalancing investment portfolio, risk, risk tolerance, stock market, Uncategorized

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With the end of the year fast approaching, it is an excellent time to discuss the concept of rebalancing one’s investment portfolio.  The simplest definition of rebalancing is the periodic reallocation of an investment portfolio back to the original percentages desired.  The fluctuations of the financial markets over time will inevitably alter the amount of exposure in one’s investment portfolio to different types of assets.  These changes may cause the portfolio to be suboptimal given an individual investor’s financial goals and tolerance for risk.  Knowing about rebalancing is so important because it is one of the most effective ways to eliminate, or at least reduce, the emotions surrounding investment decisions that affect even professional investors.  Additionally, numerous academic studies have concluded that 85% of the overall return of an investment portfolio comes from asset allocation.

Recently, I published a three-part series of articles to define and explain the various nuances of rebalancing an individual investor’s investment portfolio.  The first article covers the definition of rebalancing in its entirety.  Furthermore, the article looks at an illustration of how rebalancing works in the real world.  It offers an introduction to this important investing tool.  The link to the complete article can be found here:

https://latticeworkwealth.com/2015/07/16/how-to-rebalance-your-investment-portfolio-part-1-of-3/

The second article discusses a unique way to get assistance with rebalancing an investment portfolio.  Many of the largest asset managers in the financial services industry, such as Vanguard, Fidelity, and T Rowe Price, offer life cycle or target date mutual funds.  These mutual funds have a predefined year that the individual investor intends to retire.  Moreover, the combination of assets in the mutual fund is structured to change over time and become less risky as the target date approaches.  Since these mutual funds report their holdings on a periodic basis, any individual investor is able to replicate the strategy for free.  Plus, another feature is that an individual investor can be more conservative or aggressive than his/her age warrants according to the mutual fund family’s calculations.  The individual investor is able to pick a target date closer than the endpoint (i.e. more conservative) or pick a target date later than the endpoint (i.e. more aggressive).  For a more comprehensive discussion of this facet of rebalancing an investment portfolio follow this link:

https://latticeworkwealth.com/2015/07/29/how-to-rebalance-your-investment-portfolio-part-2-of-3/

The third and final article discusses the most advanced feature of rebalancing utilized by a subset of individual investors.  The investing strategy is referred to as dynamic rebalancing in most investment circles.  Dynamic rebalancing follows the general tenets of rebalancing.  However, it allows the individual investor to exercise more flexibility during the rebalancing process of the investment portfolio.  Essentially the individual investor determines bands or ranges of acceptable exposures to asset classes or components within the investment portfolio.  For example, a lower bound and upper bound for the asset allocation percentage to stocks is set.  The individual investor is free to allocate monies to stocks no less than the lower bound and no more than the upper bound.  Note that the bands or ranges are normally fairly tight and applies to the subcomponents of the investment portfolio, such as small cap stocks, emerging market stocks, international bonds, and so forth.  To learn more about this fairly complex aspect of rebalancing follow this link:

https://latticeworkwealth.com/2015/11/21/how-to-rebalance-your-investment-portfolio-part-3-of-3/

The articles above capture the vast majority of information individual investors need to know about rebalancing an investment portfolio.  It is good to get a head start on learning about or reviewing this topic prior to the end of the year.  The reason is that most rebalancing plans utilize the end of the calendar year as the periodic adjustment timeframe.

How to Rebalance Your Investment Portfolio – Part 3 of 3

21 Saturday Nov 2015

Posted by in asset allocation, finance, financial advice, financial goals, financial markets, financial planning, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, passive investing, personal finance, portfolio, rebalancing, rebalancing investment portfolio, risk, risk tolerance, stock market

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This rebalancing discussion is the last installment of a three-part series.  The first discussion defined what is commonly referred to as rebalancing one’s investment portfolio.  Rebalancing is in simplest form is realigning an investment portfolio to a desired asset allocation after time inevitably changes its composition due to the normal fluctuations in the financial markets.  Rebalancing is normally done at set intervals of time of which once a year is the most common.  The link to the full discussion of part one can be found here:

https://latticeworkwealth.com/2015/07/16/how-to-rebalance-your-investment-portfolio-part-1-of-3/

The second discussion outlined a relatively easy way to come up with an allocation for an investment portfolio and how it is rebalanced.  This particular method is to rely on what are commonly referred to as target date or life cycle mutual funds.  These mutual funds offered by some of the largest asset managers in the financial services industry recommend a given asset allocation for an investment portfolio based upon the year one is retiring.  The mutual funds are carefully crafted to take into account risk levels in addition to reaching financial goals.  Additionally, these mutual funds are periodically adjusted over time to keep the investment portfolio aligned with a desired asset allocation.  Bottom line, the asset manager does all the work for you and can be a nice way for novice investors to get their “feet wet” when it comes to investing.  Note that the discussion also outlines how to increase or decrease one’s risk profile (meaning take on more risk to capture possibly higher investment returns or take on less risk to possibly lower the amount one’s investment portfolio might go down by) while still using this approach.  The link to the full discussion of part one can be found here:

https://latticeworkwealth.com/2015/07/29/how-to-rebalance-your-investment-portfolio-part-2-of-3/

The third and final part of the rebalancing discussion will focus on what I define as dynamic rebalancing.  Dynamic rebalancing may be called by different names depending on the investment professional, but the concept is generally the same.  Dynamic rebalancing is reserved for more advanced individual investors.  An individual investor needs to be comfortable with understanding the different investment options available and follow the financial markets more closely.  Dynamic rebalancing still has the basic definition of rebalancing at its core.  However, there is a bit more flexibility involved when realigning one’s investment portfolio.

Let’s dig a bit deeper into dynamic rebalancing and why it is an option for a subset of more advanced individual investors.  In order to start we need to go back to the original definition of rebalancing.  Rebalancing is looking at one’s investment portfolio at set intervals (usually coincides with the end of the year) and moving monies between asset classes.  For instance, stocks may perform better than bonds in a certain year so the investment portfolio has a higher exposure to stocks at the end of the period.  In order to realign the investment portfolio back to its original composition, the investor would need to sell stocks and buy bonds.  The amounts to sell and buy are calculated such that the end result is that the percentages invested in stocks and bonds are at their original levels of the beginning of the period.  As long as one’s financial goals and risk tolerance have not changed, the original percentages are used.  It is a hard rule meaning that there are no exceptions for the final asset allocation to stocks, bonds, and cash.  The percentages are set in stone such that the individual investor does not get emotional by any short-term financial market volatility and drift away from his/her desired financial plan.

Dynamic rebalancing still has percentages for the investment in certain asset classes, investment styles, or industry sectors but a band of acceptable percentages is utilized.  For example, an individual investor would rebalance the investment portfolio at the end of the year, but he/she might decide whether to have anywhere between 65% – 70% invested in stocks.  Why would any individual investor want to use such an approach?  Well, if one looks back on financial market history, the ebbs and flows of asset classes rarely line up with calendar years.  For instance, small cap stocks might outperform other domestic stocks for two years instead of just one.  What usually ends up happening in the financial markets is that financial assets become overvalued or undervalued relative to each other as time passes.  Other investors will bid up certain stocks or bonds and sell other stocks and bonds because of the perceived likelihood of investment performance returns.  However, at a certain point in time, the scales of value tip and it becomes better to invest in the “unloved” stocks and bonds that were being sold so much in the past.  This phenomenon will hardly ever occur exactly in one-year increments.

The most important thing to remember about dynamic rebalancing is that the individual investor has financial flexibility in the asset allocation percentages, but he/she is not allowed to engage in “market timing”.  “Market timing” is when any investor believes he/she knows exactly the right time to buy or sell financial assets.  In fact, the financial media will always have financial pundits being interviewed or write investment articles predicting when the stock market will peak or when the market is at the lowest level it can go so investors just have to buy.  Professional investors might predict one or two tops or bottoms of the financial markets, but there are only a handful of them that can make a living at this approach.  If it is too hard for the professional, institutional investors to do so, individual investors should not have the hubris to think that they can.

Here is an illustration of dynamic rebalancing to make things much clearer.  An individual investor will have defined percentages to invest in certain asset classes for the investment portfolio, but he/she will also have a band of acceptable percentages.  The following is a hypothetical investment portfolio of $1,000,000 using dynamic rebalancing:

1)  Investment Portfolio at the Beginning of the Year
Type of Asset Dollar Amount % in Port Overall
Large Cap Stocks              $300,000 30.0%
Mid Cap Stocks                  125,000 12.5%
Small Cap Stocks                  100,000 10.0%
International Stocks                  200,000 20.0%
Emerging Market Stocks                    25,000 2.5% 75.0%
Domestic Bonds                  150,000 15.0%
International Bonds                    50,000 5.0% 20.0%
Cash                    50,000 5.0% 5.0%
Total           $1,000,000 100.0% 100.0%
Type of Asset Low – Band High – Band
Large Cap Stocks 30.0% 40.0%
Mid Cap Stocks 10.0% 20.0%
Small Cap Stocks 10.0% 15.0%
International Stocks 15.0% 25.0%
Emerging Market Stocks 0.0% 5.0%
Domestic Bonds 15.0% 30.0%
International Bonds 5.0% 15.0%
Cash 5.0% 25.0%
2)  Investment Portfolio at the End of the Year after Assumed Market Fluctuations
Type of Asset Dollar Amount % in Port Overall
Large Cap Stocks               $275,000 26.6%
Mid Cap Stocks                  150,000 14.5%
Small Cap Stocks                  160,000 15.5%
International Stocks                  175,000 16.9%
Emerging Market Stocks                    10,000 1.0% 74.4%
Domestic Bonds                  175,000 16.9%
International Bonds                    40,000 3.9% 20.8%
Cash                    50,000 4.8% 4.8%
Total            $1,035,000 100.0% 100.0%
Type of Asset Low – Band High – Band
Large Cap Stocks 30.0% 40.0%
Mid Cap Stocks 10.0% 20.0%
Small Cap Stocks 10.0% 15.0%
International Stocks 15.0% 25.0%
Emerging Market Stocks 0.0% 5.0%
Domestic Bonds 15.0% 30.0%
International Bonds 5.0% 15.0%
Cash 5.0% 25.0%
3)  Steps Taken to Dynamically Rebalance the Investment Portfolio
Type of Asset Dollar Amount Buy or Sell
Large Cap Stocks               $35,000 Buy
Mid Cap Stocks                            0 No Action
Small Cap Stocks              (40,000) Sell
International Stocks                   5,000 Buy
Emerging Market Stocks              (10,000) Sell
Domestic Bonds              (20,000) Sell
International Bonds                 25,000 Buy
Cash                   5,000 Buy
Total                         $0
4)  Investment Portfolio After Dynamic Rebalancing
 Type of Asset  Dollar Amount % in Port Overall
Large Cap Stocks               $310,000 30.0%
Mid Cap Stocks                  150,000 14.5%
Small Cap Stocks                  120,000 11.6%
International Stocks                  180,000 17.4%
Emerging Market Stocks                                – 0.0% 73.4%
Domestic Bonds                  155,000 15.0%
International Bonds                    65,000 6.3% 21.3%
Cash                    55,000 5.3% 5.3%
Total            $1,035,000 100.0% 100.0%
 Type of Asset  Low – Band High – Band
Large Cap Stocks 30.0% 40.0%
Mid Cap Stocks 10.0% 20.0%
Small Cap Stocks 10.0% 15.0%
International Stocks 15.0% 25.0%
Emerging Market Stocks 0.0% 5.0%
Domestic Bonds 15.0% 30.0%
International Bonds 5.0% 15.0%
Cash 5.0% 25.0%

Here are the salient pieces of information to note when reviewing the hypothetical scenario above.  At the beginning of the year, the individual investor allocates the investment portfolio amongst a number of options.  The options are large cap stocks, mid cap stocks, small cap stocks, international stocks, emerging markets stocks, domestic bonds, international bonds, and cash.  Note that the individual investor has opted to define bands for acceptable percentage exposures to these investment options.  The investment amount of the asset allocation in each category is within the band.  Additionally, assume the individual investor has established acceptable and desired percentage exposures to the overall asset class.  The percentage allocation to stocks is between 70.0% – 80.0%, to bonds is between 20.0% – 30.0%, and to cash is between 0.0% – 15.0%.  Note that the sum of the bands will not equal 100.0%; however, the investment portfolio at any given time will always add up to 100.0%.  In the third part of the hypothetical scenario, there are changes to the investment portfolio in terms of buying, selling, or doing nothing because of the dynamic rebalancing process (in part because some of the bands are violated).  When reviewing the fourth part, the balances and percentage allocations reflect those changes and the percentages do not match the percentage allocations from the first part.  They do not need to as long as the rules for the bands are followed at an overall level and specific-component level.

The hypothetical scenario can be adapted to any investment portfolio size and number of components in the investment portfolio.  Furthermore, the bands of acceptable exposure to asset classes overall or more specific investments can be lower or wider.  The main point of the bands is that the individual investor has more control over the asset allocation of the investment portfolio.  With that being said, the individual investor is not allowed to become too greedy or too fearful.  There are times when a certain type of investment performs extraordinarily well and becomes an ever larger portion of the investment portfolio.  If the percentage allocation exceeds the band though, the amount invested must be reduced to limit risk.  On the other hand, there are times when a certain type of investment performs quite poorly and becomes a rather low portion of the investment portfolio.  It might be tempting to sell the entire portion of the investment portfolio.  Generally speaking though, an individual investor should have exposure to a number of investment components and not try to determine when it is right to avoid one altogether to remain diversified.

In summary, one will note that dynamic rebalancing is much more complicated than using hard and fast rules for the absolute value of percentages allocated to each investment component.  It should really only be used by more advanced individual investors.  Thus, I would urge caution before deciding to implement the dynamic rebalancing approach to your investment process.  I would mention that it is very important to shy away from any investing strategy in general that is too complex to understand.  It is easy to be confused even more as time passes and make critical investing errors in the future.  As it relates to rebalancing, an individual investor may want to start with the standard usage of rebalancing discussed in parts one and/or two of this three-part series.  Dynamic rebalancing might be an option for the future, or you may even start your own hypothetical paper portfolio with this method to learn more.  Lastly, dynamic rebalancing does not need to be used.  I only offer it as a tool that is appropriate for a subset of individual investors.  Therefore, you should not view dynamic rebalancing as an investment strategy that must be utilized in the future once rebalancing is fully understood.  It is perfectly acceptable to stick with normal rebalancing and never even begin using dynamic rebalance as an investment strategy.  Moreover, some individual investors using dynamic rebalancing get carried away and start trying to “time the market” which would be a far worse result.

How to Rebalance Your Investment Portfolio – Part 2 of 3

29 Wednesday Jul 2015

Posted by in asset allocation, bond market, bonds, Consumer Finance, financial advice, financial goals, financial markets, financial planning, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, personal finance, rebalancing, rebalancing investment portfolio, stock market, stocks

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In the first part of the discussion on rebalancing your investment portfolio, I outlined its definition and the most common method to do so. The web link to that particular post is listed below:

https://latticeworkwealth.com/2015/07/16/how-to-rebalance-your-investment-portfolio-part-1-of-3/

As a reminder, the definition of rebalancing is the periodic adjustment of one’s investment portfolio back to the original allocation percentagewise to the various asset classes. Over the course of time, the financial markets will vary up and down and one’s investment portfolio will change. However, the individual investor will normally have a plan on how to invest in order to reach his or her financial goals while being comfortable with the amount of risk taken by investing in the various asset classes (i.e. stocks, bonds, cash, etc.). Thus, rebalancing is simply ensuring that the investment portfolio is back in line with the original parameters of asset allocation.

In this second part of the discussion on rebalancing your investment portfolio, I will show you a different way to rebalance your investment portfolio. The same general concept applies, but, using this method, one can rely on actual published financial advice. The nice thing about this particular method is that the financial advice is free and from the most and trusted asset managers in the financial services industry. Does that sound too good to be true? Well, I invite your skepticism. That is always a healthy trait whenever someone discusses investing. Let’s delve into this a bit deeper and see if I can’t assuage your fears.

Many of the asset managers in the financial services industry offer something called target date mutual funds or life cycle mutual funds. The naming convention depends on the mutual fund company, but the financial product is the same. The idea behind these mutual funds is that they invest in a certain combination of stocks and bonds depending on when the money is needed. The mutual fund will invest more of the investment portfolio in stocks in the beginning and gradually shift that percentage to bonds and cash as the target date approaches. For example, someone who is forty years old now (2015) and wants to retire at age sixty-five would invest in a target date 2040 mutual fund. Some of the asset managers offering these financial products include Vanguard, Fidelity, and T Rowe Price. The web link to each of these mutual fund families’ offerings are listed below:

Vanguard – https://investor.vanguard.com/mutual-funds/target-retirement/#/

Fidelity – https://www.fidelity.com/mutual-funds/fidelity-fund-portfolios/freedom-funds

T Rowe Price – http://individual.troweprice.com/public/Retail/Mutual-Funds/Target-Date-Funds

Now I will not personally recommend any specific financial product; however, all these mutual fund families have excellent reputations and long track records. The benefit of this rebalancing method is that you can choose a particular target date or life cycle mutual fund that lines up with your financial goal and timeline. Each of these mutual fund offerings must periodically report their investment holdings to investors and are displayed on the mutual fund family’s website. As an individual investor, you need only replicate the recommended investments in that mutual fund. Adjusting your investment portfolio either semiannually or annually is normally sufficient. The added bonus is that you can alter the target date or life cycle mutual fund you select if your risk tolerance is different than what is offered in that portfolio. If you want to take on more risk for potential added rewards in performance returns, you can select a mutual fund with a target date later than your age would indicate. For instance, assume it is 2015 and you want to retire in 30 years, you might opt for the target date 2050 instead of 2045. Conversely, if you want to take on less risk because you are more sensitive to financial market volatility, you can select a target date closer than your age would indicate. In this case, assume it is 2015 and you want to retire in 30 years, you might opt for the target date 2040 instead of 2045. Let’s take a closer look at how this works in terms of the nuts and bolts.

For purposes of illustration only, I will utilize the product offerings of the Vanguard family of mutual funds. Assume that it is 2015 and you have 20 years until retirement (2035). Furthermore, assume that you have a normal risk tolerance for financial market volatility. If that is the case, you would select the Vanguard Target Retirement 2035 Fund (Ticker Symbol: VTTHX). The asset allocation of that target date mutual fund as of June 30, 2015 is as follows:

Asset Allocation as of June 30, 2015
Mutual Fund Percentage
Vanguard Total Stock Market Index Fund 53.9%
Vanguard Total International Stock Market Index Fund 28.1%
Vanguard Total Bond Market II Index Fund 12.7%
Vanguard Total International Bond Market Index Fund 5.3%
Total 100.0%

Essentially you now have an investment portfolio that selects investments for your investment portfolio to achieve your financial goals without paying a Financial Advisor. Those investment advisory fees may be 1% to 2% (or higher) of your total investment portfolio each year. Using this rebalancing approach those fees are avoided, but you are still able to see what professional money managers are recommending for free. Now there are two courses of action at this point. First, it is possible to simply invest in this particular fund through the Vanguard mutual fund family. However, you will incur additional expenses for the fund family to manage the money and make the periodic percentage allocation adjustments. Those expenses do vary by fund family and are normally somewhat reasonable but are higher at some companies than others. Second, it is possible to invest monies into ETFs or index mutual funds that match the percentage allocations to the various asset classes. Admittedly, there are times when the commissions incurred to do so are higher than simply having the mutual fund family invest in the various funds for your investment portfolio. With that being said, there is a way to invest in ETFs for free.

One of the nicest offerings that not enough people know about is that Fidelity Investments offers the BlackRock iShares ETFs free of commission. While not all of the iShares are offered, there are currently 70 ETFs registered in the program. These ETFs have some of the lowest expense ratios (percentage fee charged on assets; normally 0.20% or less per year) in the business, and the range of ETFs should cover most any recommended target date or life cycle mutual fund investment pieces you might choose to use. The current list of the iShares ETFs from Fidelity that are free from commissions are as follows:

Commission-Free iShares ETFs at Fidelity Investments – https://www.fidelity.com/etfs/ishares-view-all

The reason one would use this method to build an investment portfolio and rebalance along the way is that expenses are minimized throughout the investing process. Many investors are not aware how much “seemingly small” expenses add up and compound over time. Decades and/or years worth of fees as small as 0.50% or 1.00% annually can erode thousands, tens of thousands, or more from your investment portfolio. Which makes it harder for you to reach your investment goals or necessitates taking on more risk in order to reach the goal than you might be comfortable within your investment portfolio. (For more information on that topic, you can view one of my earliest blog posts via this web link: https://latticeworkwealth.com/2013/07/11/is-learning-about-investing-worth-it-how-about-224000-or-320000-worth/).

Here’s a summary of the usefulness of this particular rebalancing approach for your investment portfolio. You may know when your financial goal is going to come due to pay or provide for, have a general idea of the risks you are willing to take, and know a bit about the types of asset classes for investment available. However, you may lack the confidence or specific expertise to know how to create an investment portfolio and allocate percentages of money to the various asset classes. The nice thing about this method is that you can “piggyback” off of the investment ideas of some of the best money management firms in the financial services industry. You initially invest the money in your investment portfolio as is indicated on the mutual fund family’s website. Then every six or twelve months (preferably mid-year or end of the year; the most common interval is twelve months) the investment portfolio is rebalanced to exactly match the way the target date or life cycle mutual fund is currently invested in.

How to Rebalance Your Investment Portfolio – Part 1 of 3

16 Thursday Jul 2015

Posted by in asset allocation, bonds, Consumer Finance, finance, financial advice, financial goals, financial markets, financial planning, Individual Investing, individual investors, investing, investing advice, investing tips, investments, personal finance, rebalancing, rebalancing investment portfolio, risk, risk tolerance, stock market, stocks

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The first and foremost decisions for an individual investor is to determine his or her financial goals, assess his or her risk tolerance, and then develop an investment portfolio to allow one to reach those financial goals. Financial goals might be saving for retirement, a child’s college education, disbursing income while in retirement, or most any other thing that requires money to be paid in the future. Risk tolerance involves an individual investor’s willingness to take on volatility and variability in the performance returns of financial or real assets. Some investors are fine with the sometimes wild gyrations of the stock market. They might be able to withstand a 20% decline in the value of their investment portfolio and still not panic and sell. Other investors are more risk averse and do not want to see so much volatility in their investment portfolios. However, they may know they need the growth in their investment portfolio, so they reduce their exposure to stocks. Lastly, some investors may be nearing their financial goal and need to ratchet down risk in order to have enough money by not losing principal. The final step is to construct an investment portfolio that brings the two together. The financial goals can be reached but within the parameters of the investor’s risk tolerance. Note that risk tolerance in a general sense refers to the volatility of assets in one’s investment portfolio. For instance, US Treasury bills are much less volatile than stocks.

Now the financial markets will change over time as prices go up and down. Therefore, the original allocation (percentages) to stocks, bonds, cash, or other assets in the investment portfolio will be different than the one after one year goes by. It would be markedly different after five or ten years go by. That is where rebalancing your investment portfolio comes in. In this first part of this three-part discussion, I will focus on the easiest way to rebalance an individual investor’s portfolio. In the next two parts, I will expand the notion of rebalancing. In its simplest definition, rebalancing one’s investment portfolio refers to the periodic changes made to bring the investment portfolio back to the original allocation to the various investment selections. Let’s explore why this should be done.

Due to the natural ups and downs of the financial markets, an individual investor’s investment portfolio will change in composition. Remember that an investment portfolio is initially set up to allow the individual investor to reach his or his financial goals while still adhering to the amount of risk that he or she is willing to take. Well, after a year goes by, the chances are very good that the amount of money invested in stocks, bonds, cash, etc. will have changed. Thus, the investment portfolio may be more risky or less risky than intended. Moreover, the investment portfolio may not be on track to allow the individual investor to achieve his or her financial goals which is the overall goal to begin with. Additionally, rebalancing allows the individual investor to “sell high and buy low” in general. Stocks and bonds have a way of getting too expensive or too cheap as time goes by. However, the individual investor can sell the asset class that has gone up and use those funds to buy the asset class that has gone down. The technical term that you might hear is reversion to the mean. That means that over long periods of time, financial assets tend to produce an average rate of return. Hence, a rate of return much higher than the average for several years is normally followed by a period of lower returns than the average. Now let’s turn to an example with actual numbers to make things much clearer.

We can take the following scenario with various assumptions. They are as follows: the individual investor has a portfolio of $1 million at the beginning of the year, the asset allocation is 60% stocks ($600,000), 30% bonds ($300,000), and 10% cash ($100,000), during the year the stocks gain 10% ($60,000), the bonds lose 2% ($6,000) and the cash earns no interest, and, finally, the individual investor is committed to rebalancing the investment portfolio at the end of every year.

Here is the scenario:

1) Investment Portfolio at the Beginning of the Year
Type of Asset Dollar Amount Percentage
Stocks $             600,000 60.0%
Bonds                300,000 30.0%
Cash                100,000 10.0%
Total $         1,000,000 100.0%
2) Investment Portfolio at the End of the Year
Type of Asset Dollar Amount Percentage
Stocks $             660,000 62.6%
Bonds                294,000 27.9%
Cash                100,000 9.5%
Total $         1,054,000 100.0%
3) Investment Portfolio After Rebalancing
Type of Asset Dollar Amount Percentage
Stocks $             632,400 60.0%
Bonds                316,200 30.0%
Cash                105,400 10.0%
Total $         1,054,000 100.0%

As you will note above, the investment portfolio starts out with the intended asset allocation for this individual investor. However, at the end of the year in accordance with the rate of return assumptions, the investment portfolio is quite different. In fact, the percentages for each asset class have changed. In the scenario detailed above, the investment portfolio at the end of the year is more risky than at the start of the year. That is where the rebalancing comes into play. In order to get the investment portfolio back to the original asset allocation, stocks need to be sold and the proceeds invested in bonds and cash. It is fairly easy to come up with the necessary purchases and sales by multiplying the total balance at the end of the year by the desired percentage for the investment portfolio for each asset class. That step will show how much should be bought or sold in order to restore the investment portfolio to harmony.

Please note that the $1 million and asset allocation types and percentages were selected for the purposes of illustrating the concept of rebalancing. The scenario listed above will work with any investment portfolio dollar amount. In addition, there is no reason why more specific asset classes cannot be added to the investment portfolio to match your individual investment portfolio (e.g. large cap stocks, international stocks, emerging market bonds, etc.). As long as you have the desired percentages for your portfolio, you can go through the same process in the example above in order to rebalance your portfolio.

In summary, rebalancing on a periodic basis is a way to ensure that the individual investor is on track to achieve his or her financial goals while not taking on too much or too little risk to get there. It is a way to stay on the path to one’s financial plan. Normally individual investors will rebalance their investment portfolios once a year, typically at the end of the calendar year. However, there is no reason why the length and/or time of the year cannot be altered. For the purposes of simplicity, a hard and fast rule of each year at the end of the year is usually the best rule of thumb when it comes to rebalancing for most novice individual investors. One of the other benefits is that rebalancing allows individual investors to not try and time the market or stay with a certain type of investment too long. As a personal anecdote, I have an uncle who got caught up in the Internet Bubble of the late 1990s into 2001. He devoted more and more of his retirement portfolio to technology stocks. When the bubble burst, his investment portfolio was devastated. Unfortunately, he had to delay his retirement by nearly ten years due to this mishap. Adherence to a strict schedule and rebalancing plan acts a buffer against occurrences like this. It really helps to take much of the emotion, which most investors of all types struggle with, out of investing.