Portfolio rebalancing: How to pursue growth and manage risk

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1 Portfolio rebalancing: How to pursue growth and manage risk September 2015 Regularly adjusting your investments can help you balance risk and return while you move toward your goals. It s easy to recognize when events in your life a birth, marriage, college graduation or retirement may trigger a change in your investment portfolio mix. But over time, market fluctuations also can make gradual changes to your investments and your risk exposure even if you do nothing at all. These shifts, called portfolio drift, may not be obvious because they can happen gradually. If you re not regularly paying attention, they can skew your asset mix and expose you to more risk. Keeping your portfolio in sync with your goals That s why it s so important to periodically monitor and adjust the amounts of stocks, bonds and cash in your portfolio to keep them in sync with the targeted percentages you ve chosen, says Anil Suri, managing director, chief investment officer, multi-asset class modeled solutions, Merrill Lynch Investment Management & Guidance. The portfolio rebalancing process is a critical and often overlooked maintenance step, Suri says, even though it can help you better align your investment strategy with your goals. Systematic rebalancing can help investors focus on the value of their entire portfolio and not just individual performance. Anil Suri, managing director, chief investment officer, multi-asset class modeled solutions, Merrill Lynch Investment Management & Guidance Rebalancing also may help you avoid trading on emotion. As markets or investments soar or fall, many investors succumb to fears that they may be missing an opportunity or risking their principal, he notes. Systematic rebalancing can help investors focus on the value of their entire portfolio and not just individual performance. Key Points Over time, market changes may cause the proportion of stocks, bonds and short-term investments in your portfolio to shift potentially exposing you to more risk. Regularly rebalancing your portfolio can help keep you in alignment with your risk profile, stay on track with your goals and avoid making impulsive investment decisions in difficult markets. There are several methods for rebalancing your portfolio. The key is to select an approach in sync with your style of investing and stick to it. Consider trading costs and tax consequences whenever you make any changes. Merrill Edge is available through Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S), and consists of the Merrill Edge Advisory Center (investment guidance) and self-directed online investing. MLPF&S is a registered broker-dealer, Member SIPC and a wholly owned subsidiary of Bank of America Corporation. Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value

2 Asset allocation Portfolio drift and asset weightings This chart shows how a portfolio with a moderate 60/40 stock-to-bond ratio that was never rebalanced was pushed out of alignment several times between 1987 and 2014 by market trends, with its equity holdings rising to above 80% at times. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1986 Bonds Stocks Protection from impulsive trading In fact, says Suri, research shows that investors could improve returns by as much as 5% if they don t give in to reactive behavior like impulsive trading or buying high and selling low S&P Discomfort can cause investors to sell at market lows, locking in losses when they should be staying with their investments, says Michael Liersch, managing director, head of Behavioral Finance and Goals-Based Development, Merrill Lynch Wealth Management. Maintaining your target allocation by consistently rebalancing your portfolio can help protect you from trading based on emotions, especially during periods of market volatility, Liersch concludes Source: Bloomberg, Merrill Lynch Investment Management & Guidance (IMG). Results shown are based on indexes and are illustrative. They are gross of fees, do not take into account tax implications or transactions costs, and assume reinvestment of income. Stocks and bonds are represented by the S&P 500 Total Return Index and the Barclays U.S. Aggregate Total Return Bond Index respectively. Asset allocation does not ensure a profit or protect against a loss in declining markets. Past performance does not guarantee future results S&P 500 Index The discipline of rebalancing Rebalancing also imposes a degree of discipline in investing. With rebalancing, you would be prompted to take profits when investments perform better than expected and reinvest those returns in underperforming asset classes. While this may initially feel counterintuitive because you may leave some profit on the table, and riskier because you re investing in a sector that has been out of favor, it s a strategy that has worked over time, notes Suri. If you have your doubts, he says, consider what happened in the aftermath of the financial crisis of After a decline of about 53% in the S&P 500 between October 2007 and March 2009, many shell-shocked investors avoided stocks. But after such a steep decline, stocks were undervalued, and history shows it was, in fact, a good time to buy. (The S&P 500 Index doubled in value between March 2009 and May 2011.) Start with a mix of assets that fit your goals, risk and timeline Before you start a program of regularly monitoring and rebalancing your portfolio, you first need to set targets for how much of your portfolio you want to allocate to stocks, bonds or cash a process known as asset allocation. The targets you set will reflect not only your tolerance for risk, long-term goals and liquidity, but also how long you have to pursue your goals. For instance, if you re saving for your child s college education, you might consider investing a portion of equity holdings in more conservative investments as your high school student approaches graduation. The same is true for retirement. The closer you get, the less risk you may want to assume in your investment choices. (See Counting down to retirement, page 3, for more.) 2

3 Weighing stocks vs. bonds When you weigh the long-term performance of stocks against bonds, the results show how stocks have, over the long haul, performed better but exposed investors to greater risk. These numbers are why, despite the risk, many investors choose to hold more stocks than bonds (at least until retirement). Stock market historical rates of return Avg. annual return Best year (1954) Worst year (2008) Positive years vs. negative years 11.0% 52.6% -37.0% 54 vs Source for stock market returns: Merrill Lynch IMG Investment Analytics, Ibbotson. Stock Market: S&P 500 Total Return. Past performance does not guarantee future results. 2 Source for fixed-income returns: Merrill Lynch IMG Investment Analytics. Fixed-Income: U.S. Long-Term Government Total Return. Past performance does not guarantee future results. On the other hand, if you have a higher risk tolerance and a longer time frame for your goals, you might want to consider alternative, sometimes more volatile, investments, which may give you exposure to precious metals and other commodities or real estate. The mix you choose should reflect a level of risk that suits your investment style, your time frame, your liquidity needs and your financial goals. Counting down to retirement Fixed-income historical rates of return Avg. annual return Best year (1982) Worst year (2009) Whatever investment mix you select, it s critical to review it as retirement nears. For most pre-retirees, this means limiting exposure to riskier assets, such as stocks while still holding some stocks for their growth potential and to keep pace with inflation during your retirement. The amount of risk you take as retirement gets closer will depend on your circumstances. If your savings can 5.9% 40.4% -14.9% Positive years vs. negative years 48 vs. 21 generate the income you ll need, you may not want to take on more risk. If they fall short and you re trying to make up for lost time be careful about increasing your stock investments and taking on too much more risk. (For more tools and resources to help you create an investment mix for your situation, including the Asset Allocator, see How Merrill Edge can help on page 7.) Why is it important to diversify? As you make asset allocation decisions, keep in mind the importance of diversification spreading money across various investment types or within an investment category, among a variety of companies, sectors or global regions. Diversification helps reduce the overall impact of a drastic increase or decline in the value of one asset class. If you primarily hold stocks, for example, a market downturn can substantially reduce your portfolio s value. One way to potentially mitigate this risk is to invest some of your funds in bonds and cash. These investments may provide a lower return, but they also represent less risk and don t tend to move in the same direction as stock prices. You also can diversify within asset classes. For example, you may choose to invest in large-company and smallcompany stocks as well as domestic and foreign stocks. Or you may pick a mix of investment-grade and highyield bonds. Regardless of how you decide to select your investments, remember that diversification: Can potentially lower your overall risk exposure and your portfolio s potential for volatility. Is most effective when the types of investments you choose have different reactions to the market what investment professionals call negative correlation. Essentially, this means that when one type of investment performs poorly, the other will likely perform well. 3

4 Asset allocation affects performance Ultimately, how you allocate your assets among various investments affects how well your portfolio performs. Academic studies show that asset allocation decisions may be primarily responsible for the long-term return you achieve. 2 Poor short-term performance in one particular asset class may be disappointing, but it should not be viewed in isolation. When you evaluate how your assets are allocated, remember that the big picture how all of the assets work together to help you pursue your long-term investment goals is what matters. How an asset allocation can change over time Consider James, an investor who, at the end of 2008, chose a moderate level of risk for his portfolio and the corresponding allocation of stocks, bonds and cash. As the stock market marched upward, James did not make any changes to his portfolio. By the end of 2014, his allocations and his risk level looked quite different from his selected target allocation. Because James didn t rebalance his portfolio at any time over the six-year period, he has ended up with a more aggressive stock allocation than he initially chose. This exposes him to more risk than he s comfortable with. Target allocation Allocation 6 years later ember 31, 2008 ember 31, 2014 Cash Bonds Stocks The danger of setting and forgetting As your investments deliver varying rates of return stocks may outperform bonds or vice versa market forces will cause the value of your holdings in various asset classes to change. For example, if you started with a 60/40 allocation in favor of stocks, you may end up closer to 75/25 after a bull market such as the one between March 2009 and May 2011 when the value of the stocks in the S&P Index nearly doubled. That s why, once you ve settled on the right asset allocation for each of your investment goals, you ll still need to monitor those portfolios over time and adjust for any changes to your risk profile caused by portfolio drift. For example, although your stock holdings may be worth more after a bull market run-up, they may suddenly represent a larger portion of your overall portfolio, unintentionally exposing you to more risk as shown in the chart at left. A systematic rebalancing would prompt you to take some of those profits and reinvest them in bonds to help bring your allocation back to your original 60/40 allocation. Some investors are hesitant to sell when the market is still up and maybe even rising, but by doing so you could potentially lock in your gains, explains Suri. This strategy, however, sometimes carries a cost. (See The costs of rebalancing, page 6.) 5% 3% 35% 60% 22% 75% low risk high risk low risk high risk Merrill Lynch Global Wealth Management, August The Strategic allocations are identified by Merrill Lynch Global Wealth Management and are designed to serve as guidelines for a year investment horizon. The Merrill Lynch Global Wealth Management models allocate assets among specified asset classes and, within each class, reflect broad investment diversification. The models are designed to provide allocation benchmarks based on risk/return profiles. 4

5 A hypothetical rebalancing This example of what rebalancing a portfolio entails shows how an investor will take profits on stock gains to get that percentage back down to 60 and then buy bonds to increase that holding. While the sale of the stock may have lost some upside potential, the investor has clearly locked in the gain. Asset class Original allocation Accumulated gains/losses Balances/allocation over time Action taken to rebalance New balance Stocks $60,000 (60%) +8% $64,800 (62.7%) sell $2,760 $62,040 (60%) This is a hypothetical example of how to rebalance a portfolio meant for illustrative purposes only. Past performance does not guarantee future results. The assumption behind rebalancing, Suri says, is that anything unplanned that happens to your portfolio deserves scrutiny to make sure your portfolio is still aligned with your goals, investment strategy, liquidity needs, time horizon and risk tolerance. Bonds $30,000 (30%) -5% $28,500 (27.5%) buy $2,520 $31,020 (30%) Cash $10,000 (10%) +1% $10,100 (9.8%) buy $240 $10,340 (10%) Keep in mind that, depending on the period of time being considered, rebalancing will not always produce higher returns. For example, during a bull market for stocks, Total $100,000 (100%) +3.4% $103,400 (100%) $103,400 (100%) rebalancing requires selling assets that are trending higher while buying assets that are trending lower. At that point, a snapshot of a portfolio that has been rebalanced and one that has not may show an advantage to the one that has not been rebalanced. However, when the markets shift direction, the investor who has rebalanced has the potential to maintain higher returns. Choose a rebalancing method There are several methods you can use to rebalance, and each has unique benefits, costs and risks. The one you choose is a matter of personal preference. Some common ones are: Periodic (time-based) rebalancing. In this calendar approach to rebalancing, you set a schedule, such as annually, and rebalance your portfolio according to that time frame. Every 12 months, you would measure your actual investment mix against your target. Based on the variation and any changes in your personal circumstances, you would decide whether to make modifications or wait another year to rebalance. Tolerance-band (percentage-based) rebalancing. With this approach, you establish specific thresholds that if crossed trigger rebalancing. Let s say you decide that your target allocation for stocks is 60%, with a +/-5% range. Under this scenario, if a stock market rally causes your allocation to rise above 65%, you would sell some of your stock holdings to get back to your target 60% allocation. Conversely, if it fell below 55%, you would sell bonds or money markets and use the money to restore your allocation to 60%. The tolerance-band approach triggers transactions only when there is a significant change in your asset 5

6 allocation. However, this approach means you must monitor your allocations more frequently than periodic rebalancing, which may only require you to check your weightings annually. Using other purchases and sales to rebalance. Often investors make regular portfolio contributions or withdrawals that can help them rebalance at a reduced cost. For example, if you make: Regular contributions to investment accounts: Consider investing some of that money in a category that has fallen below your designated allocation. For instance, if you own too much in stock-based investment vehicles or your stock holdings have appreciated beyond their allocation, you might use your contribution to buy a bond investment to bring the asset allocation back to the original target. Required minimum withdrawals from a retirement plan: You can use the withdrawal to reduce investment categories that have been inflated with rising prices. If you do not make regular contributions or withdrawals, you still can save some rebalancing fees by being opportunistic. What if you get a bonus and you decide to invest it? Use the money to help rebalance your portfolio. Even though you will still face fees, they will be less since you won t have to sell anything just to rebalance. There is no hard-and-fast rule that says one method of rebalancing is better than another. At Merrill Lynch, we recommend that investors consider a combination strategy, using both periodic annual rebalancing with tolerance bands of +/-5% for each asset class, says Suri. That provides a reasonable balance between benefits and costs. You also may want to consider timing your annual review to coincide with any year-end search for tax losses that could potentially help offset gains in taxable accounts. The key to rebalancing is to select an approach in sync with your style of investing and stick to it. The costs of rebalancing Rebalancing usually requires you to sell certain assets and buy others, and these transactions come at a cost: If you trade stocks, you may be subject to commission charges. If you trade mutual funds, you could incur short-term trading fees or sales charges. If you trade bonds, you may pay dealer concessions. There also may be tax consequences. If you sell a security held in a taxable account at a profit, you will be subject to short-term or long-term capital gains taxes. Transaction costs and taxes will detract from your long-term performance, so you may want to choose a process that requires a minimal number of transactions and realized capital gains. These are costs you must incorporate into any decision on how frequently to rebalance so you can avoid losing too much of your returns to transaction costs or taxes. Still, Suri suggests that most investors rebalance at least once a year. 6

7 How Merrill Edge can help Merrill Edge gives you the tools and resources you need to build and manage a diversified investment portfolio to help you stay on track toward your goals. To see if your current investments align with your goals, time frame and views on risk, log in to merrilledge.com and use the Asset Allocator. The tool includes: A step-by-step guide to developing your asset allocation plan The Investor Profile Questionnaire to identify a target asset mix based on your investment style Recommendations for changes to help you align your investments with your target mix To learn more about adjusting your asset allocation as you approach retirement, visit merrilledge.com/retirement. Looking for help rebalancing your investments? A Merrill Edge Financial Solutions Advisor can help you set up a target asset allocation and get started with regular systematic rebalancing. Visit locations.merrilledge.com to find a Financial Solutions Advisor at a select financial center near you. Or, call us at 888.ML.INVEST ( ), Monday through Friday, from 8 a.m. to 10 p.m. Eastern. If you are not currently a Merrill Edge client, please call 888.MER.EDGE ( ). 7

8 1 Liersch, M. & Suri, A. (2012). Innovations in Behavioral Finance: How to Assess Your Investment Personality from the Merrill Lynch Wealth Management Institute and the academic studies cited therein. 2 Determinants of Portfolio Performance, Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, Financial Analysts Journal, January/February 1995, Vol. 51, No. 1 Consult a tax professional as you consider sales of investments in your portfolio to learn about the tax consequences of frequent trading. Past performance does not guarantee future results. Investing involves risk, including possible loss of the principal value invested. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. Dividend payments are not guaranteed and are paid only when declared by an issuer s board of directors. The amount of a dividend payment, if any, can vary over time. Asset allocation, rebalancing and diversification do not ensure a profit or guarantee against loss. All asset classes are not suitable for all investors. Each investor should select the asset classes for them based on their goals, time horizon, liquidity needs and risk tolerance. Alternative investments, which may include but are not limited to Exchange Funds, Hedge Funds, Private Equity, Managed Futures, Precious Metals and select Structured Products, can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, your investment time horizon and your tolerance for risk. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors. Investments in foreign securities or sector funds, including technology or real estate stocks, are subject to substantial volatility due to adverse political, economic or other developments and may carry additional risk resulting from lack of industry diversification. Small or mid-capitalization companies experience a greater degree of market volatility than those of large-capitalization stocks and are riskier investments. Bond funds have the same interest rate, inflation, and credit risks associated with the underlying bonds owned by the fund. Generally, the value of bond funds rises when prevailing interest rates fall and falls when interest rates rise. Investing in lower-grade debt securities ( junk bonds) may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher-rated categories. There are ongoing fees and expenses associated with investing. Bear in mind that higher return potential is accompanied by higher risk. Neither Merrill Edge nor its Financial Solutions Advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument or strategy. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue Bank of America Corporation. All rights reserved. ARMVQ4G5 WP B 09/2015