Investors have experienced an inordinate amount of volatility over the last three years. Rapidly increasing inflation and interest rates in 2022 drove the S&P 500 down more than 19% and made for the worst bond market performance in recorded history with the Bloomberg U.S. Aggregate Bond index losing over 13%. Investors then enjoyed strong back-to-back years of S&P 500 performance gaining more than 20% in 2023 and 2024, in fact the largest two-year consecutive gain in more than 25 years. Bonds, however, experienced more muted performance in 2023 and 20204, returning 5.5% and 1.25%, respectively.
Many investors will build their portfolios with a stock/bond mix that reflects how they feel about accepting long-term investment risk. A very widely used portfolio allocation consists of 60% stocks and 40% bonds. Of the 60% in stocks, the investor will typically allocate a certain percentage to large capitalization (cap) stocks, mid and small cap stocks, and foreign stocks in order to achieve prudent diversification. The 40% allocated to bonds is typically invested in short and medium-term high-quality bonds, high yield bonds and even some foreign bonds in order to be adequately diversified.
So how should the investor manage their 60/40 portfolio after the markets of 2022, 2023 and 2024 with such poor stock and bond performance in 2022, and much stronger stock performance in 2023 and 2024?
There are two schools of thought as to how the investor should handle this situation – to rebalance the portfolio or simply leave it alone. Rebalancing a portfolio is the process of selling some of the portfolio holdings that have substantially gained (stocks, in our example, which are increasing the portfolio risk) and reinvesting in holdings that have not performed well, but that help contain portfolio risk.
The second school of thought is to leave the portfolio alone. The rationale is that the investor would be selling “winners” and reinvesting in “losers,” and to an extent, that is an accurate observation. The challenge comes when the market goes through a down cycle, and since the portfolio is overweight stocks (creating additional portfolio risk), the investor may experience greater losses than they otherwise would have had they rebalanced the portfolio.
Following 2022, most balanced portfolio investors experienced substantially greater losses in their stocks than they did their bonds. As a result, their 60/40 portfolio likely became a 50/50 portfolio as the percentage allocation to stocks declined due to poor performance. If the investor did not rebalance this portfolio, only 50%, instead of 60%, of the portfolio was exposed to the strong stock markets of 2023 and 2024. This would likely result in reduced portfolio performance.
The worst-case scenario, for example, would have been two years of strong stock performance followed by a very challenging year. We begin day 1 of the first year with a portfolio consisting of 60% stocks and 40% bonds as noted above. Throughout the first two years, the stock portion of the portfolio would increase as the performance of stocks was far greater than the performance of the bond holdings in the portfolio. After two years of over 20% stock performance, the original 60% stock would likely grow to 70% or even 80% of the overall portfolio.
Now enter the third year which is challenging for the stock market, for example with the S&P 500 losing more than 19% and the NASDAQ losing more than 30% (as in 2022). Let’s assume that the original 60% allocation to stocks had grown to 75% over the previous two years. In this case, 75% - rather than 60% - of the portfolio is exposed to the substantial losses. Whereas in the first case presented the investor would likely not experience the potential gain they otherwise would have achieved, in the second case the investor would likely experience a far greater loss because of the over exposure to stocks in a declining market.
Rebalancing a portfolio can be a complicated process that involves other factors such as the potential income tax consequences of selling assets with substantial gains in order to bring the portfolio back into its desired allocation. The investor may be left with the choice of experiencing an increased income tax liability, or risk being over exposed to a volatile asset class. This is when the guidance of a professional investment advisor can assess the situation and provide the investor with the available options and the potential risks/rewards of each option, as well as potential income tax ramifications of any portfolio changes.
This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.
Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved. Past performance is no guarantee of future results.