The term "rebalance" makes investing sound as simple as having your tires rotated or your alignment checked. And the basic concept is exactly that straightforward. But with interest rates stuck at historic lows, investing experts say it's become harder to keep allocations in proper balance, and that it may become even more challenging to work with traditional "equity versus fixed income" formulae as rates go higher.
True, there is still a simple strategy that holds. It makes sense to rebalance at regular intervals so your investments are aligned with your long-term financial plan. That generally means remixing the upside potential of equities with guaranteed returns of fixed income when one or the other gets overinflated in your portfolio.
But there are two simple steps to rebalancing. And a third that is incredibly difficult.
Step one: At the start of your investing life, decide your ideal mix of equity and income based on your appetite for risk and your long-term goals.
Step two: As you drive your investment "vehicle" toward its goal, check periodically, at least once a year, to see how your own mix of investments holds up as markets change. Then, adjust them in age- and risk-appropriate ways. Tax time is a popular time to perform the checkup and make contributions to retirement funds.
There is a step three—and it is way harder. As you complete your tuneup, try to sell high and buy low. Rebalancing is supposed to give investors the discipline to do that. But the old formula of shifting between stocks and bonds is just not working as it once did.
"I would move away from the price risk of bonds, and I would be worried about adding to them right now," says Charles Ellis, former chairman of the Yale Endowment who is now on the investment advisory board of Rebalance IRA, which offers individual advice and tools for retirement account holders. "I would be looking for another form of income. When it comes to fixed income, you have to consider if I really need that, and if I can I get income in any other way."
For example, he notes that the common stock dividend for AT&T is about the same as its bonds, at just over 4 percent. Buying the common stock probably makes more sense since common-stock dividend payers have been boosting payouts from their historically high cash reserves. Bonds, with fixed yields, do not offer that advantage.
In keeping a balanced portfolio, debt securities have nearly always provided a natural hedge: Bonds usually gain in value when stocks go down. Their yields rise proportionately when stocks go up in an improving economy. For decades, rebalancing provided a virtuous circle that way, and as a result, it kept people from letting emotions rule investments, says Ellis. That rule still holds, even if the asset mix is changing.
The rule of thumb has traditionally been "your age minus 100." It tells you roughly how much equity you should have. Doing that math, at age 40, your equity should be 60 percent and the rest should be fixed income. At 60, those numbers are flipped, with 60 percent in fixed income and 40 percent in stocks. Following the crash of 2008, those who followed the rebalance rule "have done very well," says Cam Albright, director of asset allocation at Wilmington Trust Investment Advisors.
Is there a "new normal" for rebalancing now? Normal rebalancing rules would suggest that with a 25 percent gain in stocks since the start of last year, investors should start lightening up on equities by the same percentage. Meanwhile, they should be buying bonds to restore that balance. But bond prices are so high, and yields so low, that many investing allocation experts are leery of loading up on more fixed income, especially with the Federal Reserve is in its sixth year of keeping interest rates low, and rates expected to rise when the policy ends.
"We have looked more at the income-producing side of equities and recognize equities as good income-producing properties," says Albright. "Unlike bonds, they can increase dividends. They grow up with time. There is a lot of benefit right now to think about the income coming about of equity and not just from fixed-income securities. It's a transition people have had to make the last couple of years."