Fine-tuning your portfolio for the new year
The past year was not easy on investors. Between the crisis in Greece, the market turmoil of August and September, and the first interest rate hike in nearly a decade, 2015 was a year to rattle nerves.
The market's tumble at the start of 2016 trading is giving investors little reason to believe the new year will be any gentler. But before you go into a defensive crouch, remember that this could be a great time for you stop, think, and plan.
You may have sold some losing positions at the end of 2015 and managed to reduce your upcoming tax bill. Good for you – and now you need fine tune your new investment mix. Experts recommend that you first determine your needs and priorities, and then decide which investment mix will match those needs.
Your priorities may include things like your time horizon — or how long until you might need the money for other purposes — and your appetite for risk. Perhaps none of this has changed since you last rebalanced, but you still need to make sure your investment allocation reflects your goals.
While it does not pay to rebalance too often (every time you do, you incur transaction costs and potentially realize investment gains), it's a good idea to consider doing so after you have harvested tax losses. Too often, people allow their portfolio mix to shift over time, which can be detrimental.
Vanguard in November published a study on asset allocation, and found that for global assets under management in open-end and exchange-traded funds, stock allocations reached 62 percent on Dec. 31, 2006. They then fell as low as 38 percent in 2008, during the financial crisis. After years of solid or strong returns, stock exposure then rose to 56 percent as of Dec. 31, 2014.
"Assets under management," the report said, "tended to drift based on market performance."
That kind of drift could pay off in the short run: If stock market returns are robust for two years in a row, holding off on rebalancing after year one would give you overexposure to a strong asset class. But allowing your exposure to one asset class to get too big can sharply increase the volatility in your returns.
Vanguard analyzed calendar year investment returns from 1926 through 2014 and found that an all-stock portfolio would have delivered an annualized return of 9.7 percent. But returns for at least one year declined 43.5 percent.
A portfolio invested half in stocks and half in bonds would have produced an annualized return of 8.1 percent, or 83.5 percent of the all-stock portfolio. But the balanced portfolio's worst annual return would have been a decline of 22.7 percent, roughly half as poor as the all stock portfolio's worst year.
Risk appetite and investment time horizon are personal choices, but minimizing taxes is virtually a universal goal. To that end, it is a good idea to consider how rebalancing will affect your tax bill.
If you are a long-term investor with some of your assets in a tax-sheltered account, consider concentrating your rebalancing moves there, according to analysts at Morningstar.
"Even if you sell winners that you hold within your 401(k) and IRA and use the proceeds to bump up your weightings in laggard holdings in those same accounts, you won't pay capital gains taxes," they wrote.
If you do need to rebalance in a taxable account, you can avoid adding to your tax bill by using new money, rather than selling investments you already have.
As for where to put your money, experts have no shortage of opinions. Inflation is one factor where views are shifting.
"Headline inflation will rise across developed markets, bringing core inflation closer to target," Goldman Sachs said in its 2016 outlook. That, in turn, could drive further interest rate hikes, the firm said — perhaps more than investors expect.
Strategists at JPMorgan Asset Management also expect a modicum of inflation, or as John Bilton, head of global multi-asset strategy, wrote in a recent report, "low inflation but not no inflation."
In addition, Bilton wrote, the dollar's rise will likely slow after strong appreciation in 2015, which should allow corporate earnings to recover. As a result, he recommended being overweight on U.S. and European stocks.
Adam Parker, Morgan Stanley's chief U.S. equity strategist, expects "low- to mid-single-digit" returns for equities, a guardedly positive forecast. However, he is relatively optimistic about the financial and consumer discretionary sectors.
Rebalancing can by unsettling: After all, when you do it, you are selling assets that have performed well and loading up on your recent losers. But rebalancing can help you from selling in a panic when markets experience a sudden fall, wrote Charles Rotblut, a vice president at the American Association of Individual Investors and the editor of its journal.
"Rebalancing lessens the blow of bear markets, making it easier to stick with stocks," he said. In addition, rebalancing restores a sense of control. Rather than being left wondering what the best decision is for your portfolio based on what the pundits are saying about market direction, you have a strategy that prompts you to act and gives direction on how to do it."
And, of course, having a strategy just may be the best investment plan of all.