Rebalancing Your Portfolio After The Rebound

Call it what you will, cyclical bull market or secular bear market, there's no denying that the last two years have been good to Wall Street.

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Fueled by better-than-expected corporate earnings and aggressive steps by the Federal Reserve to pump more money into the economy, the S&P 500 index has nearly doubled from its bear market bottom of March 2009. The Dow Industrialshave also surged back.

For many investors, though, the wounds inflicted by the two most recent bear markets — the dot-com collapse in 2000 and the financial crisis seven years later — have permanently altered their appetite for risk.

Some still sit on the sidelines, mere spectators of the current rally, while others are letting their emotions dictate their equity positions.

What they should be doing instead is revisit their asset allocation to determine whether it still fits their financial profile, says Zach Ivey, a financial planner with Bridgeworth Financial in Birmingham, Ala., and rebalance as needed to insulate against future market dips.

“In light of the rapid recovery in the market, it is extremely important for investors to look again at asset allocations for two main reasons,” says Ivey. “First, the growth of all asset classes has not been equal, which causes riskier assets to outpace safer investments. This growth causes portfolios to unintentionally drift toward a more aggressive position.”

Secondly, he notes, the “mathematical underpinning” of valuation in all asset classes has changed dramatically: “Just because you liked certain assets at their unbelievable low valuations in March of 2009, does not mean you like them equally today.”

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Given the state of geopolitical uncertaintyworldwide, however, and growing economic threats domestically, building a bulletproof portfolio these days takes more than stocks, bonds and cash.

“In order to be considered diversified, an investor must now include alternatives in their portfolio,” says Gregory Olsen, a certified financial planner with Lenox Advisors in New York. “Commodities, REITs, managed futures and hedge fund strategies such as merger arbitrage are no longer just for the wealthy.”

The traditional asset classes that help make a portfolio more conservative, he says, including bonds and cash, “have excess risk at this time due to inflationary pressures that have already shown signs of working their way into our economy,” says Olsen. “Due to this fact, bonds and cash should be minimized in favor of alternatives and dividend-producing stocks.”

With too much “easy money” in the system, a function of the Federal Reserve’s series of quantitative easing, says Olsen, signs of inflation are already working their way into the system, and interest rates are likely to rise over the next two to three years, putting bond holders in a position to lose money.

As such, an unprecedented 25 percent of Lenox Advisors’ model portfolio is currently allocated to alternatives, with 20 percent in bonds(mostly tax-friendly municipals), 50 percent in equities and 5 percent in a cash position “to take advantage of opportunities.”

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Christine Benz, director of personal finance for fund tracker Morningstar, agrees inflation is a wild card.

Because rising interest rates often accompany higher-than-average inflation, she says, investors should be cautious about venturing into long-duration bonds and bond funds.

“They might also consider delegating a portion of their bond portfolios to a truly flexible bond fund like PIMCO Total Return or Metropolitan West Total Return ,” she suggests.

Exposure to Treasury Inflation Protected Securities, or TIPS, of course, also provides direct protection against rising prices, but Benz notes these investments have enjoyed a “very strong performance of late and arguably aren’t very cheap right now.”

“Investors should therefore consider building their positions over a period of several months rather than adding exposure in one fell swoop,” she says.

Morningstar’s picks? Vanguard Inflation-Protected Securities , and for enthusiasts of exchange traded funds it likes the “low cost, no-nonsense” iShares Barclays TIPS Bond fund.

Benz says investors should also consider adding an inflation-adjustment feature to any annuity or long-term care insurance they own, which costs more but helps to insulate your future purchasing power, along with a floating-rate (or bank-loan) fund that seeks to protect against both inflation interest rate hikes, like theFidelity Floating Rate High Income fund.

Historically, exposure to emerging markets like Latin Americaand developing Asia has also served as an effective inflation hedge, since those countries tend to be heavy on basic-materials producers, and are beneficiaries of higher demand and prices.

Getting Pickier About Stocks

While investors should generally be diversified across all stock sectors, those looking for short term tactical moves, according to Schwab’s latest Sector Views report, should consider energy stocks, which will continue to benefit from increased global demand and a regulatory environment in Washington that could improve with the new congressional mix.

Despite its outperform rating, though, Schwab suggests “investors who racked up nice profits during the past month look to take some off the table as a near-term pullback is certainly possible.”

U.S. Over Europe

Schwab also gives the information technology sector a rating of “outperform.”

“With large cash balances, increasing dividend payments, solid management and tight inventory controls, the tech sectoris far more stable than it was in the late 1990s environment that so many still remember,” the report sates. “We believe those who remain invested in tech will be rewarded with outperformance in the coming months.”


Over the short term, financials are also expected to benefit from increased business loan demand, merger and acquisition activity, and the continued wide interest rate spread, says Jason Polit, a portfolio manager with Charles Schwab, which upped the sector to “marketperform” from “underperform.”

And while the firm acknowledges the challenges facing utilities, it notes that sector too remains “somewhat attractive” as investors search for areas of the market that pay a bit more in dividends.

“We’re still bullish on the U.S., particularly large cap stocks,” says Olsen. “There’s a very accommodative Fed policy right now for larger companies. Interest rates are low and able to really drive bottom line profits and earnings expectations, and we think that’s going to continue” for the near term.

Europe, particularly Spain, Portugal, Italy and Ireland, merits caution, he says; Germany is still “absolutely” on his investment radar screen.

For the non-equity portion of its balanced growth portfolio, Polit says the remaining 30 percent should be allocated to bonds, 5 percent to cash, and 11 percent to alternative investments like real estate investment trusts, commodities and equity-market neutral strategies in which the hedge manager goes both long and short on stocks in the same sector or industry.

For tactical investors, commodities have been hard to ignore, posting some impressive gains over the last year, led by oil and gold.

The Goldman Sachs Commodity Index has returned nearly 20 percent over the last 12 months and an eye-popping 78 percent since 1999.

But it’s also suffered a 30 percent loss over the last three years.

“Inflation tends to make commodity prices run up to the point where they overshoot like in 2008, so it’s important to use commodities but understand their volatility is very high,” says Polit.

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Benz agrees, adding, “With commodities I’d keep the stakes limited because of their potential volatility — ditto for bank-loan funds,” she says. “Anywhere from 5 percent to 10 percent of a portfolio in either category seems like plenty.”

Due to the complexity of rebalancing one’s portfolio with alternative assets, Benz notes target date funds, which automatically become more conservative as the investor approaches retirement, “can be a solid set-it-and-forget-it solution for people who don’t have the time or inclination to find an appropriate asset allocation,” she says. “I also like how these funds put a lot of different investments under the hood of a single vehicle.”

Because they are “blunt instruments,” however, a target-date fund that makes sense for one 45-year old may not work for another “so you need to make sure you’re comfortable with the asset allocation,” says Benz.

Morningstar’s favorite target date funds include the series offered by both Vanguard and T. Rowe Price.

Selecting an asset allocation that’s appropriate for you will not only serve to minimize risk in your overall portfolio, but also help you achieve your long-term financial goals.

Perhaps the biggest benefit, though, is that it gives you the intestinal fortitude to stay the course when the bottom falls out of the market. And it will happen again, says Polit.

“Don’t obsess about keeping up with the market and let your discipline and strategy guide you through volatile times, which can increase your long term success,” he says. “We can’t predict earthquakes, but we can be certain that within the next 10 years there will be another flood, geopolitical or otherwise, and we have to have our portfolios positioned appropriately before it happens.”