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Post #15 – Managing your Investments in a Bear Market

This post will discuss an investment principle that is both simple to understand and easy to implement, the practice of “Re-balancing.” Re-balancing is a concept that many of you may already be familiar with. But I think it is one of the most important investment management principles you can follow, especially in a long term bear market as we are currently experiencing.

I believe the practice of periodically re-balancing your portfolio is the most under-emphasized concept in investing. Many studies show that the average retail investor does not re-balance their portfolios very often. This is to their detriment. I have mentioned in previous blog posts that most retail investors have a difficult time controlling their emotions when the equity markets encounter a strong down draft and how important it is for an investor to maintain their discipline. Re-balancing is the solution to maintaining investor discipline and the best way to keep your emotions in check during sharp market declines.

What I like about re-balancing is that, it’s a simple practice that forces an investor to “buy low and sell high.” Many market studies show this is something many investors have trouble doing, especially during a severe bear market.

For those unfamiliar with the concept of re-balancing, let me provide a simple example. Re-balancing can be employed with as many asset types as you may want to invest in; large stocks, small stocks, bonds, cash, real estate, emerging market stocks, precious metals, etc.  In a future post I will provide some sources on how to break down your assets into more asset types. But to keep this example simple, we will assume you are monitoring a $100,000 retirement portfolio in just three large asset classes; US large stocks, international stocks, and bonds.

We will also assume, after reading Post #12 to Post #14, you have selected an equity allocation of 60% or $60,000. Further you have decided this equity allocation should be split evenly between US equities and international equities which translates into $30,000 for each equity type. The “Before Market Move Table” illustrates how your investments would break down.

Before Market Move Table

Let us now assume that, after some time has passed, there has been some upward movement in the equity markets. Your original asset allocation as shown in the “Before” table has changed. The upward move in the equity market has increased your total portfolio value to $125,000. However, because of the increase in the markets, your equity assets have increased to 72% or $90,000 (split evenly between US and international equities) and your bond assets have decreased in value from $40,000 to $35,000 which now represents 28% of your total portfolio as shown in the “After Market Move Table.”

After Market Move Table

The concept of re-balancing is simply selling some asset classes and buying other asset classes to bring your asset allocation back to your original allocation. In our example you would sell $7,500 of both your US equities and your international equities and use this $15,000 to buy more bonds. This action decreases your equity allocation from 72% back to 60% allocation and increases your fixed income (bond) allocation from 28% back to 40%. Your asset allocation has now returned back to your original selected asset allocation of 60% equity and 40% fixed income. The “Re-balanced Table” shows how your asset allocation will look after you have taken the re-balancing actions. That is all that needs to be done to re-balance your portfolio.

Re-balanced Table

Alternately, in another scenario, the equity markets go down and your equity funds are reduced to $50,000 while your bond assets have increased from $40,000 to $50,000. Your overall portfolio value would still be $100,000 but you would then have a 50% /50% split between your total equity assets and your bond assets. In this case, you would sell $10,000 of your bonds and use the $10,000 to purchase your two equity asset types in the appropriate amount to bring your asset allocation back to your original allocation of 30% US stocks, 30% international stocks, and 40% bonds.

What has re-balancing done for you? In our example, when the equities increase in value and you sell some to re-balance your portfolio, you have forced yourself to lock in your equity gains (i.e., sell high). In the alternate scenario, where your equity assets had decreased in value, you then sell some bonds and buy more equities. You have now forced yourself to buy equities when they are lower in cost (i.e., buy low).

How often should you re-balance your portfolio? Like almost everything else in stock market investing, there is a lot of disagreement on this. My opinion is younger investors (in their 20s to 40s) do not have to re-balance as often, but I think younger investors should review their portfolios once a year and consider re-balancing at that time if the equity allocation has changed by 10% or more (i.e., if your chosen 60% equity allocation changes to less than 50% or more than 70%). However, I would re-balance at any time between portfolio reviews when there is a sharp market move and your portfolio moves appreciably away from your chosen asset allocation. Most sharp market moves (such as 10% or more equity increases or declines) tend to be over reactions to economic data or world events and they give the investor a chance to take advantage of temporary market dislocations.

One more note here for younger investors: Some financial advisors suggest that people in their 20s and 30s should consider having 100% of their assets in equities since they are so far from retirement. I would not do this. The financial crisis of 2008-2009 provided a good reason why. If you were 100% in equities in 2008 when the financial crisis began, what fixed income asset would you have sold in order to buy more equities when they were down in value? Obviously you would not have been able to do this, and you would have missed out on a great opportunity to buy equities when they were down. Some financial advisors will say that this does not matter because being younger will allow you to make up for this missed opportunity over the rest of your investing years. Hopefully that will happen. But what if we stay in the current secular bear market for another decade? It is best to always have some assets in fixed income no matter what your age.

Investors in their 50s and 60s, before retirement, should consider re-balancing their portfolios annually as well. Even if you are close to retirement and the equity markets experience a significant decline, I think you should still re-balance by purchasing equities. This should not be risky if you have already dialed back your equity allocation (see Post #12 to Post #14) to reflect your age and proximity to retirement. A lower equity allocation means you should have a large cash buffer to maintain portfolio stability.

However, in the end, each investor must decide for themselves how often (and at what threshold) they should re-balance their portfolios. But remember, re-balancing more often may reduce your returns, but it also acts as a form of risk reduction. If you are close to your retirement savings goal, this is an important consideration.

When the equity markets are rising many investors get greedy and do not want to sell their equities. In not selling their equities, these investors may increase the value of their portfolio today, but it is possible that the market may follow this increase with an equal or greater decline and these investors may end up losing those gains (or worse they actually decrease their portfolio value).

Conversely, when equity markets are falling, fear kicks in and investors want to sell all their equities to avoid further losses. Again, this could avoid some losses in the short term, but then an investor must decide when to buy back into the equity markets. This is where most retail investors make mistakes. They have trouble overcoming their fear while the markets were declining and are hesitant to buy back into the equity markets until they have stabilized and often miss the majority of stock market rallies. How many of you missed the market rally from spring of 2009 to spring of 2011? You would have been better off doing nothing from the beginning of the financial crisis in 2008 until spring of 2011 (I know many of you are now nodding your heads).

If there is one thing that all market experts agree on, it is that no one knows what the markets will do in the short term and trying to time the market is a fool’s game. If you just follow a disciplined practice of periodically re-balancing your portfolio, not only should you not be hurt by any future market turmoil, you most likely will come out ahead. If this seems difficult to believe, read my next post. I will provide a real life example. How I re-balanced my portfolio throughout the 2008-2009 financial crisis and how it moved our retirement date up by two years.

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