Why You Should Be Taking a Hard Look at Your Investments Right Now

All eyes were on the Federal Reserve this past week, or so several market analysts solemnly said. This was true even though the Fed essentially did nothing in its latest meeting but hold interest rates high to fight inflation, just as it has done for many months.

To be fair, there was a little news: The Fed did appear to affirm the likelihood of rate cuts starting in September, and that’s important. But so are the big performance shifts in the market, away from high-flying tech stocks like Nvidia and toward a broad range of less-heralded, smaller-company stocks. In fact, there’s a great deal to think about once you start focusing on the behavior of the markets and the health of the economy in an election year.

But what is perhaps the most important issue for investors rarely gets attention.

In a word, it is rebalancing.

I’m not talking about a yoga pose but about another discipline entirely: the need to periodically tweak your portfolio to make sure you’re maintaining an appropriate mix of stocks and bonds, also known as asset allocation. If you haven’t considered this for a while — and if nobody has been doing it for you — it’s important to pay attention now because without rebalancing, there’s a good chance you are taking on risks that you may not want to bear.

The rise in the stock market over the last couple of years, and the mediocre performance of bonds, has twisted many investment plans and left portfolios seriously out of whack. I found, for example, that if you had 60% of your investments in a diversified U.S. stock index fund and 40% in a broad investment-grade bond fund five years ago, almost 75% of your investments would now be in stock. That could make you more vulnerable than you realize the next time the stock market has a big fall.

Asset Allocation

The Securities and Exchange Commission defines asset allocation as “dividing an investment portfolio among different asset categories, such as stocks, bonds and cash.” It’s an important subject, but it’s not as straightforward as that description seems.

“The process of determining which mix of assets to hold in your portfolio is a very personal one,” the SEC says. “The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.”

I’m in total agreement with that cautionary note. Considerable academic research has shown that broadly diversified investments in stocks and bonds through low-cost index funds are a good approach over long periods. But exactly what mix of stocks, bonds and cash (including money market funds, Treasury bills, savings accounts and certificates of deposit) is right for you is difficult to pinpoint in the abstract. It’s up to you.

The most common asset allocation is the so-called 60/40 portfolio — containing 60% stocks and 40% bonds — and it makes sense as a starting point. The main idea is to split your holdings between stocks and bonds in such a way as to find the best trade-off for you between risk and return.

Because stocks have produced higher returns than bonds have, this portfolio emphasizes stocks but holds a sizable dollop of bonds because they typically hold value, providing stability. Bonds didn’t do the job in 2022. When interest rates rose, bonds fell along with stocks. But at least with this kind of portfolio, there’s a record of what the risks and rewards have been.

Whether to choose a more conservative portfolio (with more in bonds) or an aggressive one (with more in stocks) is a thorny issue. I’ll return to this problem in future columns, but for now, let’s keep things simple and focus on a basic 60/40 portfolio, invested only in U.S. stocks and bonds. (Personally, I favor a more complex, internationally diversified asset mix.)

Higher Highs, Lower Lows

Here is how a 60/40 portfolio, tracking the entire U.S. stock and investment-grade bond markets, would have performed from 1926 through 2023, according to Vanguard:

— Average annual return, 8.7%.

— Worst calendar year, 1931, with a return of minus 26.6%.

— Best year, 1933, with a return of 36.7%.

For comparison, here’s a pure stock portfolio. It has higher returns but lower lows:

— Average annual return, 10.3%.

— Worst calendar year, 1931, with a return of minus 43.1%.

— Best year, 1933, with a return of 54.2%.

If you could own stocks only in the good years, that would be ideal. But you can’t. As Todd Schlanger, a senior investment strategist in Vanguard’s Investment Strategy Group, said in an email: “It’s worth noting that the best year for stocks came shortly after the worst. This pattern is not uncommon as we have found the best and worst returns for stocks tend to be tightly clustered across markets, making timing them a difficult task.”

Bonds are less flamboyant. Here are the historical returns for a pure investment-grade bond portfolio. The worst year for bonds happened recently:

— Average annual return, 5.1%.

— Worst calendar year, 2022, with a return of minus 13.1%.

— Best year, 1982, with a return of 32.6%.

Control What You Can

In short, stocks produced better returns over the long haul, but at the cost of periodic steep declines. Bonds were less spectacular but more likely to have been there for you if you needed the money in any given year.

By increasing the proportion of stocks in your portfolio, you are probably increasing your potential for rewards — at the cost of sharply increasing your risk of big losses. That’s what happens to many people if they haven’t rebalanced.

Because of the way the markets have behaved in recent years — with big gains for stocks and mediocre returns for bonds — many portfolios are now heavily skewed toward stocks in ways that their owners never intended.

I found, for example, that if you had never rebalanced, a 60/40 portfolio containing two Vanguard index funds — Total Stock Market and Total Bond Market — would have switched over the five years through June to a 74/26 stock/bond portfolio. That’s because the stock fund gained 93% while the bond fund declined 0.59%.

You may be tempted to just leave well enough alone in the hope that the stock fund will keep rising. I can’t say that’s the wrong move, just that when I’ve allowed that to happen to my investments, I’ve regretted it because eventually the stock market has fallen, and it’s hurt. As Schlanger says, great years in the stock market are often followed by terrible ones.

It’s worth asking whether you can handle the full brunt of a major stock decline. If that question gives you pause, it may be time to cash out some of your stock gains and use the money to buy bonds. (Yes, this can set off tax problems if you’re not using a tax-sheltered account, so be careful.)

One justification for selling stocks and buying bonds may come from all the news about the Fed and possible interest rate cuts. When rates fall, after all, bond prices rise, and bond funds tend to produce gains. So, for that reason, this may well be a good time to buy bonds.

But it also may not be. The truth is, no one really knows, and I don’t believe it’s wise to try to time the markets. Rebalancing is a simpler idea, one you can follow regardless of the news about stocks or bonds.

Your workplace investment fund or financial adviser may already be rebalancing investments for you. If so, that’s one less thing to worry about. But it’s worth checking. Every so often — say, once a year, or, perhaps, when your stock/bond proportions veer sharply — restore an asset allocation that’s prudent for you.

“Get back to where you once belonged,” as the Beatles sang.

The ephemeral movements of the markets always get attention. But investors over the long run need the discipline of rebalancing, too.