Investments

Rebalancing Your Portfolio: Looking at a Midyear Rebalance

By Chris Duderstadt

June 29, 2023

Rebalancing Your Portfolio: Looking at a Midyear Rebalance

Key Points – Rebalancing Your Portfolio: Looking at a Midyear Rebalance

  • What is Rebalancing?
  • Is It Time to Rebalance?
  • What’s a Good Interval to Look at Rebalancing?
  • Strategies That Can Be Combined with Rebalancing to Further Develop a Retirement Plan
  • 10 Minutes to Read | 23 Minutes to Watch

A Sweet (Summer)time to Rebalance Your Portfolio?

As we enter the second half of the year, it’s time to take a closer look at your investment portfolio and consider a midyear rebalance. Rebalancing your portfolio can help you stay on track toward your financial goals. Dean Barber and Bud Kasper explained the concept of rebalancing and its role in maintaining a well-diversified and optimized portfolio on America’s Wealth Management Show. They’re going to help us look at the benefits of periodic adjustments, keeping your risk tolerance in check, and taking advantage of opportunities.

The S&P Is Up, But Take a Closer Look at Why It’s Up

Rebalancing your portfolio is almost counterintuitive to the human psyche. If you step back and look at the big picture, the S&P and the NASDAQ are both up, so it’s easy to think that everything must be fine. It can be tempting to hold on to those positions and see how much more you can make. However, as Dean explained in his May Monthly Economic Update, we have seen a very small concentration of stocks driving the markets higher during the first six months of 2023. So, those overall market performances have been a bit deceiving.

“When you look at equal-weighted portfolios, you have the same amount of dollars in every one of the positions that are inside of that. Let’s use the S&P 500 as an example. There are 11 sectors of the S&P 500, but those sector weightings are going to be dominated by those who are having the greatest amount of success. Just 30 days ago, you had a market that was up about 9.5%. But if you took out the big five winners at that time, you we’re only about 1% positive. So, crazy things are happening inside the market. There are just a few stocks that are leading this market forward.” – Bud Kasper

Constant Rebalancing with the Equal Weight

Equal-weighted ETFs are constantly rebalancing. With the equal weight, you constantly own the same amount of everything. It can help smooth out the rise. Longer term, the cap-weighted S&P 500 has outperformed the equal weight. But we can go back to 2022 as an example. The equal weight was only down 10% where the S&P 500 was down 19%. So far this year, the S&P 500 is up 14% and the equal weight is only up 4%.

What Does Rebalancing Your Portfolio Mean?

For those people that aren’t familiar with the term rebalancing, let’s break it down. Once you’ve identified the proper asset allocation in your portfolio—how much should be in stocks, bonds, cash, international, etc.—those parts of the portfolio will perform differently at different points in time. As those perform differently, your initial proper asset allocation gets out of whack.

An Example of Rebalancing Your Portfolio

Here’s an example. Let’s say you started with a balance of 60% equity and 40% fixed income on January 1. Well, equities are up far more than fixed income, so you wouldn’t be at 60-40 anymore. You’d probably be around 65-35 or even 70-30 depending on what sector of the market you were in.

“The question then becomes, ‘Do I go back now to a 60-40 allocation, therefore protecting some of the gains that I’ve made?’ Or do I say, ‘My equity portion is doing so much better than my fixed income portion. Why would I take anything out of there and put it into fixed income?’ That’s where the rebalancing story goes against the psyche of, ‘Hey, I’m making money in this one. Why would I why would I sell some of what’s doing well and put money in something that’s not doing as well?’” – Dean Barber

Usually when we’re talking about the fixed income portion of the portfolio, we’re talking about bonds. However, we’ve seen what has happened with interest rates on shorter duration—CDs, bonds, and treasuries. The participation of CDs on the fixed income side isn’t something we’ve been used to factoring into the equities vs. fixed income equation in recent years.

You Can Also Rebalance Specific Positions in Your Portfolio

Along with rebalancing your portfolio from an equity vs. fixed income perspective to get back to your original asset allocation, you can also rebalance different positions within your portfolio. Let’s look specifically at rebalancing equity positions.

“Rebalancing forces you to go in and buy the lower-priced stocks and take the profits away from the current stocks. That doesn’t mean that the ones that you just sold aren’t going to get future gains. It just means that you’re now rebalancing back so that dominant part of the portfolio—the tech stocks that we’ll be talking about—don’t suddenly collapse and take down the entire portfolio.” – Bud Kasper

The Insanely High Price-to-Earnings Ratios in the Tech Sector

So, there are multiple ways that you should be considering rebalancing. As Bud alluded to, it would be very difficult to sell some of tech stocks—such as Microsoft, Nvidia, Apple, Google, and Meta—that are doing the heavy lifting in the S&P 500 and go buy energy, a REIT ETF, consumer staples, or those types of stocks because all those are underperforming this year and many of those have negative returns this year.

Well, the reason is because most of those tech stocks have price-to-earnings ratios that are anywhere from 30 to 315. That’s totally out of sight. At the same time, most of the P/E ratios for energy stocks in single digits. They’re cheap right now. And energy isn’t going anywhere. Demand for it is going to be there.

What’s Your Proper Asset Allocation?

Our CFP® Professionals know from meeting with people nationwide every day that most people just have investments. They haven’t really thought about a proper asset allocation strategy yet. How do you go about doing that?

“To define the proper allocation for any individual, you first need to go through the entire financial planning process. What do you want the rest of your life to look like? What do you need your money to do so you can do all the things that you want to do for the rest of your life? And what are all the resources that you have? It’s a lengthy process to discover the proper asset allocation for every individual.” – Dean Barber

Your Goldilocks Portfolio

People need to define what is their proper asset allocation. You may have heard of it being referred to as the Goldilocks portfolio. There’s the portfolio that’s too much risk, one that’s not enough to get you where you want to be and doesn’t have enough risk, and then there’s the portfolio that’s just right.

Again, to discover your Goldilocks portfolio, you need to go through the financial planning process. If you want to understand more about what all needs to be considered during the financial planning process and how to discover your Goldilocks portfolio, you can get started by reviewing our Retirement Plan Checklist.

It doesn’t focus on investing. The Retirement Plan Checklist is all about your life and preparing for retirement. When going through the 30 yes-or-no questions in the checklist portion of it, so many people discover the things that they need to be asking themselves about. What conversations do you need to have with your spouse or what questions do you need to ask your CFP® Professional to determine what your asset allocation should look like? Then, you can talk about the thought process of rebalancing your portfolio. But first, download your copy of the Retirement Plan Checklist below.

Rebalancing Your Portfolio

Retirement Plan Checklist

Another Example of Rebalancing Your Portfolio

Let’s go back to looking technology and use the tech-heavy NASDAQ as an example. If you’re of the opinion that long-term technology is going to outperform the rest of the broad market and would rather on the NASDAQ and the S&P 500. You can put up with the volatility.

The NASDAQ was down by 33% last. So, let’s say that you want to have a 60-40 portfolio, but want that 60% equities to be all the NASDAQ 100. And you want the other 40% to be fixed income. If you started out 2022 at 60-40, your 60% lost 33% and your 40% only lost 13% if you were in the bond aggregate. If you would’ve rebalanced your portfolio on January 1, you would have had to sell some of those bonds and put more money into the NASDAQ.

“From a psychological perspective, that’s a difficult thing to do. You don’t know how much further it’s going to fall. You don’t know how much longer the Fed is going to continue raising rates. So, it’s easy to hold off and wait rather than rebalancing your portfolio. Well, guess what would have happened? If you started out with 60% in the NASDAQ, you’re up 36% this year. Meanwhile, your fixed income piece is up maybe 2%. Think about the difference in your portfolio had you made that switch. It’s involves being disciplined. Once you establish what your allocation should be, you need to rebalance your portfolio without emotion.” – Dean Barber

Taking Fear and Greed Out of the Picture

Dean and Bud often talk about how fear and greed can take over when making investment decisions. The past couple of years have been a good example of how that can happen.

“Emotions were rich at that time. People were saying that the market wasn’t going to go anywhere when it was down 33% on the NASDAQ and 19% on the S&P 500. They thought it could go down further, so why in the world would they want to do that? Why would they want to sell their safe bonds, which weren’t safe last year, but take my CDs or money market account that’s paying them 4.5% and put it back into the NASDAQ or into stocks in general? That’s what we’re talking about here with rebalancing your portfolio.” – Bud Kasper

Here’s another example. We only need to go back a little more than a year to see what was happening with oil and the supply chain situation. We took from our reserves fund that are supposed to be for the military. Money was taken out of that to fill the pumps back up to drive the price back down.

That was another situation of rebalancing that could have made you money if you were in oil that was losing and you rebalanced back into that at that time. Remember that oil is only one of the 11 sectors that make up the S&P 500.

Combating Financial Uncertainty

It’s important to look at rebalancing your portfolio from a longer-term perspective. That’s difficult to do because there’s a lot of uncertainty that we’re still dealing with that’s related to several economic factors. We mentioned interest rates earlier. The Federal Reserve has paused its rate hikes for now but have already indicated that there will likely be a couple more in 2023.

“I think the pause is smart because it’s allowing the data to be collected for another 30 days to see whether what they’re doing is working. It’s the Fed’s objective to get down to 2% inflation. I think that is an incredible challenge for the Federal Reserve to get to that number. But we’ve lived most of our life at 3-3.5% inflation. We can live with that. The markets can thrive, both bonds and stocks, under that type of scenario. If they can get down to those levels, I think we’ll be a happier nation in the long run, even though it causes a little bit more angst and pain in the short term.” – Bud Kasper

Don’t Forget About Considering Taxation When Rebalancing Your Portfolio

And as we continue to talk about this whole idea of rebalancing, there’s another thing that needs to be taken into consideration. That’s taxation. If you rebalanced in January and are looking at rebalancing again, if that’s in a taxable account, you need to understand that any gains will be treated as ordinary income because they will be short-term capital gains.

What Is Direct Indexing?

Depending on your income, you could be in a 0%, 15%, 20%, or 23.8% capital gains rate. The maximum is 23.8%. That’s where you have enough total income to trigger the net investment income tax, which is the Obamacare tax.

There’s a lot that you need to take into consideration there. If you have dollars that are a taxable account and you’re buying mutual funds or ETFs, you should be looking at a process called direct indexing if you qualify.

“Direct indexing essentially takes the wrapper off the ETF or mutual fund and allows you to own the stocks that make up those indexes individually. Doing active tax-loss harvesting as the time goes on, it’s kind of doing rebalancing for you in a very tax efficient way as you’re moving through. That way you don’t have to worry about whether you’re rebalancing into a short-term capital gain environment or long-term capital gain environment? What are your tax consequences?” – Dean Barber

When you have direct indexing in your taxable accounts, that takes a lot of the guesswork out of it. Without computers, we’d never be able to do direct indexing because it’s constantly going in and rebalancing individual positions back to where they were. It forces you to take your profits and the losses, which can be a very good thing in the long run.

Tax Alpha

This is what is known as creating tax alpha. It’s an additional return because you’re more tax efficient. Now not everybody qualifies for direct indexing. When you’re buying individual stocks, you need to have a larger amount of money to do it. Depending upon the direct indexing provider, your minimums can range anywhere from $100,000 to $250,000 minimum. You need to make sure that you’re not taking up too large a portion of your portfolio with something like that, as with anything.

There’s Much More to Financial Planning Than Your Investments

We want to make sure that everybody understands that if you’re only having conversations with your financial advisor about investments, that’s a big problem. There are very complex issues with retirement planning that involve taxes, your Social Security, estate planning, health care—just to name a few—that need to be built into your financial plan.

“If you’re just talking with your advisor about investments, your portfolio probably isn’t what it should be because you’re just guessing and you’re operating on those two strong emotions of fear and greed. Always take it back to the plan and understand the right portfolio for you. Then, you can start to employ the tactics that we’ve discussed with rebalancing your portfolio.” – Dean Barber

To Rebalance Your Portfolio or Not to Rebalance Your Portfolio?

So, should you rebalance your portfolio or not rebalance your portfolio? That’s our question for you today. The only way to know is with the plan and knowing what your Goldilocks portfolio is. If you don’t have a financial plan or have some sort of plan that doesn’t include the complex retirement planning issues we just mentioned, let’s change that.

You can start building your very own comprehensive financial plan using our industry-leading financial planning tool. With our planning tool, you can build a plan that’s customized to your retirement goals so you so can live your ideal retirement lifestyle. To begin building your plan from the comfort of your own home and at no cost or obligation, click the “Start Planning” button below.

Rebalancing Your Portfolio

START PLANNING

It’s also critical to work with a team of professionals through the retirement planning process so that you truly understand things like whether you should rebalance or not. If you have questions about whether you should rebalance or want to get a better understanding of what rebalancing is, let us know. You can ask your questions during a 20-minute “ask anything” session or complimentary consultation with one of our CFP® Professionals by clicking here. We can meet with you in person, virtually, or by phone depending on what works best for you.

Rebalancing Your Portfolio: Looking at a Midyear Rebalance | Watch Guide

00:00 – Introduction
01:47 – Where is this Market Run Coming From?
02:52 – What is Rebalancing?
05:20 – Why Rebalance Now?
07:02 – TRIVIA: Where Did Wall Street Derive Its Name?
07:53 – Creating the Right Asset Allocation
12:07 – TRIVIA: When Was the DJIA Established?
13:01 – The Tech Heavy NASDAQ
16:11 – Equal-Weight vs. Cap Weight
16:48 – Let’s Talk About the Fed
17:55 – Taxation, Rebalancing, and Capital Gains
21:01 – What We Learned Today

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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.