Asset allocation and portfolio rebalancing

 

To avoid putting all of one’s financial eggs in one basket, financial experts advise investors that their portfolios should consist of various types of assets, typically cash, bonds and equities, and perhaps augmented by annuities (in retirement), real estate (aside from primary home), commodities, precious metals, and currencies. Each of these assets has an associated characteristic return and risk (or volatility).

Each asset also has subclasses, for example, government, corporate, and junk for bonds, and US, small cap, mid cap, large cap, and emerging markets, for equities. Cash and treasury bills offer the lowest return and risk especially in a very low interest rate environment. Bonds yield more and generally are held to maturity. In recent years, bond prices have been supported by investors’ demands for “safe haven”, including the US Federal Reserve Bank’s quantitative easing program (informally known as QE). With the Federal Reserve expected to raise interest rates in coming years, the US bond market is likely to see lower prices. The outlook for the worldwide government bond market is also uncertain in part because Ireland, Portugal, and Greece have massive deficits. In a worst-case scenario, investors could face a haircut, the term describing a partial loss of a bond’s face value.  Historically, equities have both the highest return and risk. Commodities and precious metals including currencies have high returns but also considerable risk. Real estate generally had a high return until the US real estate bubble of late 2007. The very high number of home foreclosures, e.g., Nevada and Florida, and number of unsold homes throughout the US still warn investors off from investing/re-investing in this asset.

Harry M. Markowitz, awarded a Nobel Prize in 1990 for his contribution to portfolio theory, demonstrated that if a portfolio has a sufficient large number of assets which have different correlations (including negative), the overall risk for the portfolio is decreased by diversification, in other words, including different types of assets.

There is a relationship between risk and return where higher returns requires higher risk. For example, if a portfolio only contains bonds with a 4% annual return, the portfolio’s value will double after 18 years. But if the portfolio contains bonds with a 6% annual return and equities with a 10% annual return, the portfolio’s value doubles after 10 years, although with more risk. Even experienced investors can become lulled by a market that seemingly goes up and up (2005-2006). When it crashes (2007-2008), their tolerance for financial risk may also drop.

Financial experts advise portfolio rebalancing, particularly after a market crash. This simply means that the monetary share of each asset’s contribution to the total portfolio should remain constant at certain intervals. In the above example of bonds and equities, the share of each asset would remain at 50% every other year, for instance. If equity prices rise sharply during the two first years, their monetary value will be more than 50% of the total portfolio, while bonds will be less. Thus, the investor would sell some portion of equities and purchase more bonds to maintain a 50% share. Rebalancing carries its own risks, since the investor may have to sell some assets when the prices are high and buy them when the prices have remained flat or fallen. In other words, rebalancing “forces” the investor to buy another asset while the price is relatively lower than the highest-yielding one. Typically, the price of bonds falls with rising stock markets and vice versa. Investors should bear in mind, though, that history is not always the best guide. Amid the financial crises of the past few years, most assets except government bonds fell sharply in price and were highly correlated.

 

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    The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk

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