A Wealth of Knowledge - Winter 2012 Issue - Portfolio Construction and the Need for Periodic Re-Balancing

When designing a well-thought-out portfolio, we believe an investor should consider the objective and time horizon as well as his or her individual risk tolerance.  The asset mix between equities, fixed income, cash and alternative investments is critical in determining the long-term expected return.  In our opinion, an investment time horizon that is less than four years should limit the overall allocation to equities and alternative investments to less than 30% and could be even lower if the individual has very low tolerance for risk.  For the remainder of this article, let’s assume that the investment time horizon is greater than ten years and the individual risk tolerance is moderate.  Let’s also assume the purpose of the investments is to supplement retirement income in 12 years over a period of no less than 25 years.

Assuming the individual has decided with the assistance of his/her advisor to invest 55% into equities, 5% to precious metal/commodity basket, 38% fixed income and 2% CDs/money markets/cash, here are some additional considerations in the current market landscape.   It would be wise to consider some exposure to inflation-sensitive investments.  There is a general concern the unprecedented size of the federal balance sheet coupled with sustained low interest rates could make it difficult for the Fed to contain future inflationary pressures.  The equity component should include some percentage to small cap and large cap equities focused on a diverse mix of sectors and classes.  Mixing in some level of emerging market and international equities would also make sense.  Depending on the individual income tax status including some municipal bonds may be warranted.  For those with modified adjusted gross income above $250,000 (Married Filing Jointly) and $200,000 (Single) in 2013, there will be an additional 3.8% surtax on portfolio income which municipal interest would avoid.  In the current interest rate environment, keeping the average maturity investments to less than four years will provide some protection when interest rates begin to rise.  There is an inverse relationship between interest rates and bond values.  Laddering or staggering the maturity of the bonds could provide a way to deflect some of the interest rate exposure while allowing for future re-investments at more attractive rates.  If using a bond mutual fund or exchange traded fund (ETF), make certain to invest in shorter duration funds that keep average maturity at less than four years.  Investors will have much less control against interest rate movements in mutual funds vs. individual bonds but proper diversification will trump this advantage.

Once the portfolio has been fully implemented, periodic review and rebalancing is a very crucial part of the investment management process.  Consider for an example the investment returns through October 31 of this year: the S&P 500 US Large Cap Equity Index – up 14.3%, Russell 2000 US Small Cap Equity Index - up 11.8%, MSCI EAFE Developed International Equity Index - up 11.0% and Barclays Capital US Aggregate Bond Index returned 4.2%.* Assuming the portfolio has been in place since the beginning of the year, it would make sense to consider rebalancing the portfolio. Based on the listed returns above, an investor would shift some assets from the equity classes into areas that have not performed as well to reset the portfolio to the originally targeted allocation.  This may seem counterintuitive to sell those assets that have done well and buy investments that have not but this disciplined approach may provide the investor much higher overall results over the long term.  Since most assets will revert to a normal mean, this manner of rebalancing ensures in some aspect to sell high and buy low.  We are not abdicating market timing which is very difficult to execute successfully over the long term but implementing some level of tactical rebalancing at least once a year should be considered.

The idea of investing assets may appear to be daunting but by including some basic principles an investor can manage very well.  Remember to include in the investment plan an understanding of the time horizon, risk tolerance and objective of the plan.  Use a diversified approach with the investor’s asset allocation mix, including domestic, large and small cap and foreign equities.  Include fixed income and possibly broad commodity exposure.  Depending on the investor’s comfort level, adding alternative investments to the mix may provide more diversification.  Consider the impact of future rising inflation on investments.  Review and rebalance the portfolio periodically.  

*Index performance typically does not reflect trading and execution costs, nor investment management fees. 

A Wealth of Knowledge - Winter 2012 Issue

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