Investors have enjoyed back-to-back strong years in the U.S. stock market with the S&P 500 gaining in excess of 20% in 2023 and 2024. Over the same time period, the U.S. bond market continues to falter, with the Bloomberg U.S. Bond Aggregate Index gaining only 1.25% in 2024. This divergence in stock and bond returns will, over time, create a challenge for investors with balanced portfolios which contain both stocks and bonds.
Most 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 in order to achieve prudent diversification. They may also include an allocation to foreign stocks.
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.
But what happens to that 60/40 portfolio when over the last two years stocks have generally performed very well, and bonds have not? Over time, the desired 60/40 allocation begins to change into a higher risk portfolio given the performance differential. It is common to see a portfolio like this become 65% stocks and 35% bonds, or even 70% stocks and 30% bonds, after two years of very different investment performance. Left untouched, that portfolio will eventually expose the investor to increasingly more portfolio risk than was originally desired.
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. So, if a portfolio with a desired allocation of 60/40 has changed to 70/30, the investor who wished to rebalance would sell 10% of the stock holdings and purchase 10% more bonds. Once the portfolio is rebalanced back to its desired allocation, it will also reflect the desired overall 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.
An investment professional can help investors first understand how much portfolio risk they are comfortable accepting and construct a portfolio that reflects that risk. Over time, assuming the portfolio is rebalanced on a regular basis, the investor is not incurring additional and unwanted portfolio risk.