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Addressing the Impact of Market Momentum

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Although contrary to virtually all investment guidance, the performance of financial markets is often a key driver of investor behavior. When equity markets are down, or after a period of underperformance, it seems a natural tendency for investors to sell their equities and buy bonds, or keep their cash on the sidelines. This has been the case for the past two years, during which time many investors have heavily favored bonds over equities—to some extent likely a conscious, lingering reaction after two painful equity market routs in the 2000s.

Although investors who have made such a move believe themselves to be reducing their risk, the opposite may in fact be true. With bonds yields increasingly paltry and cash paying next-to-nothing, the risk that these investors are taking is that their investments may not even be keeping pace with inflation. On the other hand, those who stayed in the stock market or bought in during its rise since its March 2009 lows may also be taking on more risk than they intend as a result of their increased exposure to stocks.

For either group, the consequence is the same: a portfolio with an asset allocation that's out of step with its intended target. While rebalancing can't eliminate losses or guarantee gains, it can go a long way toward helping investors achieve their financial goals.

Rebalancing Basics

As you are likely well aware, any investment portfolio should be guided by a carefully considered asset allocation plan based on an investor's risk profile, investment goals and time horizon. That plan will identify the percentage to be invested in stocks, bonds and cash. Digging deeper, it will further break down the stock allocation to domestic and international stocks, and potentially further parsing by market capitalization and geographic region. It may also include exposure to alternative investments such as REITs or commodities. Whatever the level of complexity, the intent of a plan is to provide a clear roadmap as to how investments should be distributed within an overall portfolio and, importantly, to remove emotion from the equation.

Rebalancing consists of buying or selling assets to restore your portfolio to your original target allocation. To many, it seems counter-intuitive, as it effectively requires trimming back on winners and buying assets that may be out of favor. But it's an important step in controlling risk. Think of it as a disciplined method by which to apply one of investing's chief precepts—buying low and selling high. So if stocks have risen significantly, your portfolio is likely over-allocated to stocks and underallocated to bonds; to get back on track, you would sell stocks and buy bonds. If fear has driven you to reduce or eliminate your stock exposure, rebalancing prompts you to restore your portfolio's equilibrium.

Don't confuse rebalancing with reallocation, which is shifting to a new asset allocation that reflects an entirely different risk level. That happens as you age and your goals, risk tolerance and timeline change. But if none of those things has changed, your asset allocation should remain static, at least for the shorter term. 

The Impact of Rebalancing

To illustrate the impact of failing to rebalance regularly, the Schwab Center for Financial Research studied two scenarios of a hypothetical moderate portfolio comprising 35% large-cap stocks, 10% small-cap stocks, 15% international stocks, 35% bonds and 5% cash: one rebalanced annually; the other never did, letting the market's performance dictate its ever-changing allocation. Over the 43-year period from 1970 through 2012, the portfolio that rebalanced annually posted an average annual return of 9.7%—outperforming the never-rebalanced portfolio by 0.5% annually. Over time, that 0.5% can have a surprisingly consequential effect on a portfolio's value. As important, however, is the risk that each portfolio was taking: The portfolio that never rebalanced took on significantly more risk than the one that rebalanced annually, as illustrated below.

Annual Rebalancing Can Enhance Returns and Lower Risk

Now that several key stock indexes have finally recovered and posted new all-time highs, some investors who had shunned stocks are starting to reconsider. For them, the prospect may be daunting. But there are ways to maintain opportunities for growth while minimizing—or at least managing—portfolio risk. Here are three ideas:

Go Defensively

Although an economic recovery appears to be well underway, consumers may continue to be cautious in their spending for some time to come. So there's still some wisdom in maintaining exposure to what are traditionally known as defensive stocks. While definitions vary, defensive stocks are typically those in industries where consumers spend no matter what the economic climate—such as health care, consumer staples and utilities. While funds that have a concentration in these companies may not show spectacular growth, they are more likely to realize stable and predictable earnings in both good times and bad.

Look to Dividends

Dividends can help mitigate short-term market volatility, as their quarterly or annual payments supplement changes in share price. But distributions aren't guaranteed, so it's important to have exposure to funds with a broad range of dividend-paying stocks, which can offer the potential to provide protection from the impact of a falling market while still providing attractive growth potential when markets are rising. 

Hedge Your Bets

While "hedging" connotes an investment strategy typically best avoided, hedging is simply pursuing multiple strategies toward achieving an investment goal. One way to do this is to incur some exposure to "short" stock positions, which can offset or moderate the impact of more-typical long positions. (Long positions anticipate rising prices, whereas short positions hope for prices to fall.) Although such a "long/short" strategy can lag the broader market when stocks are on the rise, it aims to reduce the downside impact when stocks are declining. 

The Bottom Line

Asset allocations can and do change over time, for good reason. But part of the value of establishing an asset allocation plan is to keep your investments in synch with your risk tolerance, so it's important to stick to your plan regardless of market gyrations. If you haven't done so recently, take a hard look at your current assets against your plan. If you're off by even a few percentage points, consider rebalancing. You can find funds that meet the criteria discussed above in Schwab's Mutual Fund OneSource Select List. After that, institute a process whereby you rebalance regularly—at least annually; more frequently if market movements have been extreme. It's an easy way to maintain discipline and eliminate emotion from your investment equation. And with it, you just may be more likely to meet your investment goals. 


Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling 800-515-2157. Please read the prospectus carefully before investing.