Rebalancing Your Portfolio

As you age, your portfolio should change.  How do you go about doing this?

Most financial advisers suggest re-balancing your portfolio over time, to reflect changes in your portfolio and also your life changes.

For example, during boom times, your high-yield stocks may take off like a rocket.  Suddenly, they are worth a lot more, and your more staid investments, like bonds, are an even smaller part of your portfolio.  Re-balancing the mix, by selling off some of the high-risk stocks and buying more low-risk, but lower-yield bonds might be in order.  This is, in effect, a form of profit taking.

And in the 1990's and 2000's, I did just that.  However, you should be careful when re-balancing a portfolio that the financial adviser is not getting a commission on each sale.  And if your adviser is telling you to buy and sell quite often, perhaps you should look into his motives for suggesting so.

The second reason to re-balance is that as you get older, your portfolio should get more conservative.  This is a good idea from both a survival standpoint and due to the law of diminishing returns.  As you approach retirement age, you will be able to take money out from your funds - at which point, it really matters less how much you are making.  The effect of compound interest lessens if the amount of time remaining is less.  So there is little to be gained by sticking with high-yield stocks, but a lot of risk - the risk of losing it all.  And at that age, you can't afford to lose it all.

Now, granted, there are some who take a different approach.  I know some folks, who have under-saved for retirement, and are trying to live off interest in earnings alone.  Their philosophy is to keep the money in high-yield stocks, earning 10% or more a year, and then spend that 10% every year.  In the 1990's and early 2000's, this was a strategy that worked - until 2008, when it all when horribly wrong.

Of course, the question is, how much to put into "safe" investments and how much to put into stocks?  Many advisers suggest using your age as a barometer.  For example, at age 25, you might want to be 25% into bonds and 75% into stocks.  At age 50, you might want to be 50/50.  And at age 75, perhaps 75% in safe investments and 25% in risky stocks.

There are some who argue that perhaps this scheme is too conservative.  Since most folks will be working longer before they "retire" it makes sense to leave the money in higher-yielding investments longer.  At age 51, I may be only 8 years away from being able to tap into my 401(k), but I am 20 years away from having to tap into it, and it could be 25 years before I need to tap into it.  Two decades is a long time, and compound interest adds up quickly.

The mechanics of re-balancing are not hard to do, for most mutual fund companies or self-directed IRAs.  You have to go online, sell some or all of your stock funds and then buy, with the proceeds, bond funds.  Some brokerages (such as Fidelity) allow you to "swap" from one fund to another, without having to wait for the sale to clear before making the purchase (which usually is 24 hours).  Some brokerages don't charge fees for such swaps, although the funds themselves have fees attached or management fees, or even "loads".  For a self-directed IRA, such as my E*Trade account, you can just sell stocks and buy bonds, if you want to, although you have to pay their $9.99 trading fee, usually, for each transaction.

Are bonds foolproof?  Well, it depends a lot on what kind of bond it is - from a U.S. Government backed Treasury bond (secure, but earns little) to a municipal bond (a little riskier, but still a pretty good bet) to a corporate bond (hope it ain't GM!).  Municipal bonds have some interesting features in that in many jurisdictions, they may be tax-free.  Obviously this is a nullity in a tax-deferred retirement plan.

And bonds and bond funds do go down in value on occasion.  If you sell a bond before its maturity date, the only buyer is someone on the secondary market who will take it off your hands.  And what they will pay for it is what the market thinks it is worth.  So if you have a GE Bond, and people get nervous about GE, the value of the bond goes down, even if GE has promised to pay you all this interest down the road.

In the old days, bonds used to come with "coupons" representing the interest payments due.  At the end of each interest period (e.g., year) you would cash in the coupon and get your interest payment.  Thus, it was possible to "strip" the coupons off a bond and sell them off separately and keep the underlying bond (which is good only for the face value at the maturity date, with no interest).   In effect, the bond was two financial instruments - a promise to pay a fixed amount in X years, and a stream of income of y% for X years.  My understanding is that these days, these types of bonds are not very common.