Rebalancing Your Portfolio

The New Rules of Investing

Brett Hammond, Chief Investment Strategist

Get Your Portfolio Back on Level Footing

Do You Have the Right Asset Mix?
Why is Diversification So Important?
Diversification and Correlation
Asset Allocation and Risk
Getting the Balance Right
Rebalance Over Time - Don't Time the Market

Do You Have the Right Asset Mix?

After one of the worst market declines in recent memory, and renewed volatility of late, you might be reluctant to even open your portfolio statement. But inaction can be a costly mistake. Now more than ever, investors need to embrace sound, long-term investment principles like asset allocation, diversification and portfolio rebalancing.

If you’ve stayed the course thus far, kudos for not panicking. But now’s not the time to rest on your laurels. Now’s the time to reassess your investment mix and perhaps rebalance your portfolio — or even confirm that your allocation was suited to your risk tolerance in the first place.

So did you have the right asset mix before the market dip of 2008, and to a lesser extent, the summer of 2010? Chances are that you’ve been more heavily invested in equities. According to a recent survey, about 40% of the 55- to 65-year-olds polled had 70% or more allocated to equities — and nearly a quarter held more than 90% in equities. With that much equity exposure, your portfolio likely stumbled at the end of 2008 and earlier this year.

Why Is Diversification So Important?

Consider two hypothetical portfolios for a 65-year-old investor from 2008:

  • John is invested 90% in equities and 10% in bonds (Portfolio A)
  • Sally is invested in a well-diversified portfolio of 60% equities, 30% bonds and 10% real estate (Portfolio B)

By the end of 2008, John’s portfolio would have suffered substantial losses of  -23.7%. Meanwhile, owing to a diverse mix of assets, Sally’s portfolio was cushioned, trimming losses to only -14.1%.

 

image of pie charts comparing portfolio performance


The returns here show past performance, which is no guarantee of future results. This is a hypothetical illustration. These returns are for illustrative purposes only and do not reflect actual (product) performance. Index performance does not reflect any fees and expenses associated with investments. Different time periods would have shown different results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate.

 

In this and subsequent charts, equities are represented by the S&P 500, bonds are represented by the Barclays Capital U.S. Aggregate Bond Index, and Real estate is represented by the FTSE NAREIT Equity REITs Index, which measures the performance of publicly traded real estate investment trusts in the United States that own, manage and lease investment-grade commercial real estate. Investors cannot invest directly in an index.

Investments in equities involve risk, including the possibility that the price of equity securities may decline in response to general market and economic conditions or events. Investing in fixed income involves certain risks and interest rate increases can cause bond prices to decline. Investing in real estate involves risks including valuation and appraisal risks, financial risk, market risk, income volatility risk and foreign investment risks.

This simple comparison powerfully demonstrates why diversification is so important.

Simply put, diversification means spreading your money out among different types of investments in the hope of getting the best possible return for the least amount of risk.

But there are different ways to diversify. For instance, you can diversify by asset class, such as stocks, bonds or cash. Or you can even diversity within an asset class, such as by style (growth vs. value), geography (U.S. vs. international) or market capitalization (i.e. the size of the company).

 

image of pie charts showing diversification within the Equity Class


Diversification does not assure a profit or protect against a loss. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate.

 

More information on equity subclasses >>

Diversification and Correlation

So diversification works by spreading out your risk. By investing in a variety of different types of investments, you are betting that some will do well when others are lagging and vice versa. But it also assumes that asset classes tend to react differently under different market conditions — something known as correlation.

Take stocks and bonds, for example. Historically, these two asset classes have had a low correlation — meaning when one is up, the other is often down.

 

image of bar chart showing calendar year total returns


The returns here show past performance, which is no guarantee of future results. Different time periods would have shown different results.

 

However, in the depths of the 2008 market meltdown, assets that historically tended to produce very different outcomes all suddenly moved in the same direction: down.

 

image of bar chart showing calendar year total returns


The returns here show past performance, which is no guarantee of future results. Different time periods would have shown different results.

 

Does this mean that diversification no longer works? No. It simply means that our typical measures are more effective over long time horizons than during periods of extreme market volatility that occur sporadically. In severe financial crises such as the one in 2008, investors abandon most types of investments for the safety of only the most liquid, short-term investments. In other words, when the bear is roaring the loudest, the entire market tends to retreat at once.

Asset Allocation and Risk

Asset allocation is the way you harness the benefits of diversification for your own portfolio. You use asset allocation to distribute your investments in a way that makes sense for your own personal goals, timeline and appetite for risk. And while the two concepts are related, it’s important to understand that you can have a well-diversified portfolio but still not have an appropriate asset allocation.

For example, what does your portfolio look like now? After the market slide of 2008, it's likely that equities made up a much smaller percentage of your portfolio than you originally intended. And if you left your portfolio untouched amid stocks' exceptional decline, an originally aggressive portfolio made up primarily of stocks may have looked rather timid in the aftermath.

 

image of pie charts comparing hypothetical market action


The returns here show past performance, which is no guarantee of future results. Market action reflects the period of capital markets decline from 7/1/07 to 12/31/08. Different time periods would have shown different results.

 

And there’s good reason to believe that you didn’t make any drastic changes. Research suggests that most investors didn’t readjusted their mix. For example, a recent analysis of online balance inquiries, fund transfers and customer call center volume all indicated that plan participants were avoiding rash decisions during that financial crisis.2 These data are backed up by human resources consultant Hewitt Associates, who found that only 6 percent of assets in 401(k) plans were shifted out of stocks and into bonds then, mostly during the most turbulent months.

While no one is advocating panicked selling, leaving your portfolio to fend for itself can also be detrimental. In fact, this sets you up for the worst of both worlds — bearing the brunt of the bear market on the way down, and not being positioned to fully participate when stocks eventually recover. That’s why it’s always important to consider rebalancing when markets are particularly volatile.

Getting the Balance Right

Rebalancing is the process of resetting the asset mix of your portfolio to match your original long-term strategy. Think of rebalancing like rotating the tires on your car. After so many miles, the treads can become more worn on one side. By rotating them, you try to restore equilibrium by making sure the treads become evenly worn over time.

When our portfolios get worn down, we need to restore their original equilibrium too. That means selling down the asset classes that have done well and grown beyond their original allocation — and increasing the allocation of asset classes that have shrunk because of poor performance.

 

image of pie charts comparing rebalancing a portfolio


Rebalancing does not protect against losses or guarantee that an investor’s goal will be met.

 

The returns here show past performance, which is no guarantee of future results. Market action reflects the period of capital markets decline from 7/1/07 to 12/31/08. Different time periods would have shown different results.

Rebalance Over Time – Don’t Time the Market

So the key to rebalancing is to buy assets when they are low, or beaten up, and sell them when they’re high. But it doesn’t mean trying to time which asset classes or indices will outperform the market at any given time — otherwise known as market timing. Most research suggests that it’s virtually impossible for individual investors to consistently time the market with demonstrable success.

There are many considerations you should take into account when rebalancing, not the least of which is whether your original mix was even suitable at the outset. At TIAA-CREF, we're here to provide you with the asset allocation and rebalancing guidance you need. Our non-commissioned consultants are compensated through a salary-plus-incentive program based on client service excellence and financial results — so our consultants will only recommend products that help achieve your goals.

 

1 Employee Benefit Research Institute February 2009 The Impact of the Recent Financial Crisis on 401(k) Account Balances
2 Shlomo Bernartzi, Anderson School, University of California at Los Angeles and T. Rowe Price Retirement Plan Services

This material is prepared by TIAA-CREF Asset Management and represents the views of TIAA-CREF's Investment Strategy and Client Solutions Group. These views may change in response to changing economic and market conditions. Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.

TIAA-CREF Asset Management is a division of Teachers Advisors, Inc., a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). TIAA-CREF® personnel in its investment management area provide investment advice and portfolio management services through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®).

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