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Note to Self: Time to Rebalance

By: Ted Black, CFP©
Winter 2024 (Vol. 41, No. 4)

Asset Allocation and Rebalancing is a topic we like to revisit each year around this time. We’ve covered this several times in the past, but as a quick reminder, “Asset Allocation” is the process of creating an investment portfolio that combines different assets (Stocks, Bonds & Cash) in varying proportions, with the ultimate goal of providing an investor with a balance between capital preservation and long-term growth that suits their particular situation. This approach was born from research that demonstrates that over long periods of time, Stocks, Bonds and Cash perform quite differently from one another, and as such, an investor’s mix of these assets proves to be a significant factor in their long- term results.

Rebalancing is the process of making adjustments (buys and/or sells) to the portfolio to bring the asset allocation schedule back to its “base setting”. And although there are no hard and fast rules as to how often an investor should rebalance their portfolio, a minimum of once per year is recommended.

This process can be particularly important in years in which there are significant differences in the performance of one’s holdings. 2023 was just that type of year. Although it was full of starts and stops, 2023 turned out to be quite a strong year for the U.S. stock markets. Meanwhile, because of the Federal Reserve Boards (The Fed) aggressive increases of interest rates in an effort to tame inflation, the last couple of years have been challenging for Bonds.

As a result of the large variance in recent performance between Stock and Bonds, one’s current allocation may differ from the original desired allocation.

For example, let’s assume that after much thought and a careful evaluation of current personal financial conditions and future financial goals, an investor decides that an appropriate asset allocation schedule calls for them to direct 60% of their investments into Stocks, 30% into Bonds, and 10% into Cash or Money Markets. If left untended, after periods in which the assets owned perform significantly different from one another, a portfolio may end up with an asset allocation schedule, and importantly, a risk/reward profile, that is quite different from its original design.

This may be a particularly good time to take a close look at one’s allocations. The Fed likes to say that their policy decisions are “data dependent”, meaning that new information regarding GDP, inflation, employment, etc. will influence their decisions moving forward. With that said, given the information currently available, it would appear that we’ve reached peak interest rates. If in fact that turns out to be the case, the question now becomes when will the Fed lower rates, and how many times will they do so.

Although the Fed has no direct role in setting the Prime Rate, it does set federal funds overnight rate, which serves as the basis for the Prime Rate. The Prime Rate currently sits at 8.5%, it’s highest level in over 20 years. If 2024 turns out to be a year in which we see several interest rate cuts, which at the moment seems likely, it could result in a solid year for Bonds.

Please keep in mind as you review your holdings that longer term Bonds react more dramatically to interest rate changes than shorter term Bonds. This is a function of a concept called “duration”. Duration is expressed in terms of years, but it is not the same thing as a bond’s maturity date, which is just one of the factors in calculating duration.

As an example, in theory, if rates were to fall 1%, a bond or bond fund with a 5-year average duration would likely gain approximately 5% of its value, a bond or bond fund with a 10-year average duration would gain approximately 10% of its value.

If you have questions about Asset Allocation or Rebalancing and how they may currently apply to your situation, please feel free to call Ted Black, CFP© at 888-878-0001, extension 3.

Advisory services offered through Royal Palm Investment Advisors, Inc., a Registered Investment Advisor.