With the S&P 500 up over 258% since 2009 and bond markets up approximately 40%, there has been a trend of equity allocations increasing among investors. Whether due to complacency with a low-volatility environment or decreasing perception of risk, investors are allocating more of their portfolio to equity. This trend could result in investors failing to review their portfolio and making sure to rebalance it.
A major takeaway from this chart is that investors typically have the highest equity allocation prior to downturns. This unplanned excess equity allocation presents risk to a client. This is especially true if they are at or approaching retirement. The time horizon is shorter and return sequences are more impactful.
An aspect of the financial independence planning for every client depends on determining an equity allocation that strikes a fair balance between the client’s goals, ability to take risk, and willingness to take risk. After we carefully determine an appropriate equity allocation, we partner with the client to maintain that equity allocation by reviewing the portfolio for rebalancing opportunities throughout the year. This continuous process helps to ensure that the client can achieve their financial goals at a risk level that they are comfortable with. If left unchecked for an extended period of time, the client’s risk tolerance and the portfolio’s actual risk could considerably diverge.
Let’s take a look at a hypothetical investor who, 30 years ago, invested $1,000 in the S&P 500 and $1,000 in bonds. This investor takes no other investment action other than reinvesting dividends and interest in each of funds. Today, this same portfolio would be worth $21,097 in stocks and $6,366 in bonds. But we need to pay closer attention to what happened here. This investor started out with a 50% equity portfolio and ended up with a portfolio at 76% equity. It’s a strong change in the risk profile of the portfolio. If the S&P 500 were to realize a downturn, this investor could lose more money than they would have expected since they are taking more risk than they realize.
Regular rebalancing codifies the investment adage “buy low, sell high” because when equities are running strong, we sell them (selling high). Likewise, when stocks fall, buy more equities (buying low). What we find is that relative to a portfolio that is never rebalanced, a regularly rebalanced portfolio experienced a greater reduction in risk than the slight return forgone. In finance, we consider this a superior solution because return is always considered as a function of risk. Since no one would take on more risk for lower expected returns, we find that rebalancing is a better way to enhance a portfolio.
Addition to Important Disclosure Information
The index returns shown above show the total return for various investment indices and include the impact of the reinvestment of dividends. A comparison to indices may not be a meaningful comparison. Comparisons to benchmarks have limitations because benchmarks have volatility and other material characteristics that may differ from the performance of a client’s portfolio. The investments in a client’s portfolio may differ substantially from the securities that comprise each index and are not intended to track the returns of any index.
One cannot invest directly in an index, nor is any index representative of any client’s portfolio. Actual client accounts will hold different securities than the ones included in each index. The index returns are gross of applicable account transaction, custodial, and investment management fees. The actual investment results would be reduced by such fees and any other expenses incurred as an investor. Please below for definitions of the indexes used.
For the illustration chart, equity allocations include the following Morningstar categories: sector equity, US equity, and international equity. Bond allocations include the following Morningstar categories: taxable bond and municipal bond. Cash allocations only include the money market Morningstar category.
For the hypothetical 30-year investor, S&P 500 returns are based on total returns of the S&P 500 beginning on 12/31/1987 and ending on 12/31/2017. Bond returns are based on the total returns of the Bloomberg Barclays US Aggregate Bond Index beginning 12/31/1987 and ending on 12/31/2017.
The S&P 500 is an index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be an indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe. Each constituent in an index is weighted by its market-capitalization, as determined by multiplying its price by the number of shares outstanding after float adjustment.
The Bloomberg Barclays US Aggregate Bond Index is a broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).
Important disclosure information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.
Please remember to contact RegentAtlantic if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.
This article is not a substitute for personalized advice from RegentAtlantic. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.
RegentAtlantic does not provide legal or tax advice. Please consult with a legal and or tax professional of your choosing prior to implementing any of the strategies discussed in this article.