Balance, Rebalance

Balance is a big deal: balance between work, family, and fun. The same is true in your financial affairs. As the size and relationships of the new global markets constantly change, it’s more important than ever to rebalance your portfolio to make sure that the allocation of your investment dollars reflects your long-term goals.

Investment professionals rebalance portfolios in several ways. The three most common are buy and hold, constant mix, and constant proportion portfolio insurance. 

Buy and Hold

This is a familiar strategy: You pick a certain mix of assets—let’s say we’re building a portfolio of stocks, bonds, and cash—and then you do nothing.

The buy-and-hold strategy is the least expensive to maintain because you don’t incur fees for services, and there are no realizable taxable gains (or losses), for the most part. As for performance, a buy-and-hold strategy tends to do well in up markets, but not so well in down and oscillating markets. One other factor: “Letting your winners run” may result in the appreciating assets having an outsized influence on the portfolio, which, of course, can be both good and bad. It’s good in that the value of your portfolio can appreciate considerably if one or more of your investments is successful, but it can be bad if those assets drop in value, resulting in losses and unwanted volatility.

A constant-mix strategy involves buying more stock as prices fall, and selling stock as prices rise so that you always maintain the same percentage of each type of asset. In contrast to a buy-and-hold strategy, a constant-mix strategy tends to do better in an oscillating market. Investors buy stock as prices fall, but capture gains as they rise.

The idea here is to sell stocks as they fall and buy them as they rise. The “insurance” piece of the strategy involves establishing a “floor” value beneath which the portfolio must not fall. This method is less common than the other two.

Let’s say we have $100 to invest and we want our floor to be $75. This means we have a $25 “cushion,” or allowed amount of losses, relative to our initial investment. To keep the proportion of assets in line, the investor selects a multiplier to determine how much stock should be in the portfolio. A higher multiplier means a higher percentage of stock—and acceptable risk—in the portfolio.

Our multiplier will be two—a common choice for an asset mix of stocks, bonds, and cash. To find out how much money we should initially invest in stock, multiply two times the $25 cushion to get $50. If the stock market heads south, and the value of our $50 in stocks drops to $45, our $100 portfolio is now worth $95. That means our cushion is now $20. So we multiply $20 times two, and the formula tells us we can have only $40 worth of stock in our portfolio—we have to sell $5 worth of stock and reinvest it in bonds to keep the proportion of assets in line. If the market continues to fall, we sell stocks until they’re gone.

Constant proportion portfolio insurance does well when the markets are going up, but not so well when the markets are oscillating. But remember, no strategy can assure success, or protect against loss. 

Editor’s note: Next month’s column will discuss when to rebalance your portfolio.