I Rebalanced My Portfolio
Thursday, October 30, 2014

I rebalanced my portfolio, or more specifically my 403(b) retirement savings account, this week. The change was made after I conducted my semiannual review. The changes offer some insight into how various asset classes have performed and how I personally manage my portfolio allocations.

Our 403(b) plan, which is the equivalent of a 401(k) plan, is operated through Vanguard. In it, I hold five funds: Vanguard 500 Index Fund (VFINX), Vanguard Small-Cap Value Index Fund (VISVX), Vanguard REIT Index Fund (VGSIX), Vanguard FTSE All-World ex-U.S. Small-Cap Index Fund (VFSVX) and the Vanguard Intermediate-Term Investment-Grade Fund (VFICX). The 500 index fund gives me access to what is arguably the most frequently used benchmark. The domestic small-cap value fund takes advantage of two factors shown to lead to higher returns: value and small company size. The FTSE small-cap fund gives me diversification via international small-cap stocks. Real estate investment trusts (REITs) have had similar long-term returns as small-cap stocks, tend to offer diversification benefits over longer periods of time and are one of the few asset classes to have a higher correlation to inflation. The bond fund provides diversification, buffers the portfolio against volatility and serves as a counter-weight I can rebalance into during bull markets for stocks and out of during bear markets for stocks. (I gave a longer explanation of my allocation, as well as the corresponding Admiral Share mutual fund and exchange-traded fund (ETF) tickers, last year. Vanguard will not allow us to hold the less expensive Admiral Share class funds in our accounts regardless of how much we have saved.)

I use an equal-weighting methodology with a target allocation of 20% for each fund. I check my portfolio twice a year—at the start of May and at the end of October—to see if it needs to be rebalanced. These two periods coincide with the change between the worst six months for stocks (May through October) and the best six months for stocks (November through April). If any allocations are off-target by more than five percentage points, I rebalance.

When I checked the account on Sunday, two funds triggered the rebalancing. The REIT fund was at 105.5% of the average position size, or 5.5 percentage points more than the targeted allocation. This is not surprising given the fund’s performance. REITs have been performing exceptionally well; Vanguard’s REIT fund is up 15.1% over the past 12 months (through October 29, 2014), according to Morningstar. The international small-cap fund was at 91.4% of my average position size, or 8.6 percentage points below its targeted allocation. International small caps have lagged, overall down 1.2% over the last 12 months. The S&P 500 fund nearly set off a rebalancing alert as well, with a weighting of 104.9% of my average position size. The fund is up 14.0% over the past 12 months.

My rebalancing process involved moving dollars out of the REIT fund and the S&P 500 fund to lower their weightings to 100% of the average position size (a portfolio weighting of 20% in each fund). I then boosted the weighting of the international small-cap fund to 100% of the average position size. The remaining balance was allocated to the intermediate-term bond fund, which was at 97.8% of the average portfolio position. The fund is up 5.78% year-to-date thanks to the drop in interest rates. Had the other funds been closer to their target allocations, I would not have adjusted the bond fund’s allocation.

The only fund I did not touch was the value small-cap fund. Though up 10.3% over the past 12 months, the fund has lagged much of this year. This resulted in an allocation of 100.4% of the average position size. Investing is messy, and there is no reason to adjust an allocation that is a mere 0.4 percentage points off of its target.

Keep in mind that the balances in my account are impacted by the timing of purchases. Because I contribute to the account through automatic payroll deductions, the dates at which new dollars are added to each fund alter both my return and the allocations. (For those of you who are curious, Vanguard says my portfolio is up 10.4% for the period of October 1, 2013, through October 27, 2014.) If no money had been added or if withdrawals had been made, the allocation percentages may have been different for each fund.

Most importantly, realize that these changes are not a market call on my part. Rather, they are a result of me adhering to a preset investment policy intentionally designed to take emotions out of my investing decisions. Staying disciplined is the most the important part of my investing process.

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The Week Ahead

State and local elections will be held on Tuesday.

More than 80 members of the S&P 500 will report earnings next week. The Walt Disney Company (DIS) is the only Dow component in this group and is scheduled to release results on Thursday.

The first economic reports of note will be the October ISM manufacturing index, the October PMI manufacturing index and September construction spending, all of which will be released on Monday. Tuesday will feature September international trade and September factory orders. The October ADP employment report and the October ISM non-manufacturing index will be released on Wednesday. Thursday will feature the first estimate of third-quarter productivity. October jobs data, including the change in nonfarm payrolls and the unemployment rate, will be released on Friday.

Several Federal Reserve officials will make public appearances next week, as is often the case following a Federal Open Market Committee meeting. Chicago President Charles Evans and Dallas President Richard Fisher will speak on Monday; Minneapolis President Narayana Kocherlakota, Richmond President Jeffrey Lacker and Boston President Eric Rosengren will speak on Wednesday; Governor Jerome Powell and Cleveland President Loretta Mester will speak on Thursday.

Monday starts the “best six-month” period for stocks. Since World War II, the S&P 500 has experienced an average return of 7.0% from November through April versus 1.4% from May through October, according to Sam Stovall at S&P Capital IQ. In a recent note, Stovall described the November through April period as having “more pronounced” seasonality following midterm elections. He wrote, “During this favorable six-month stretch, the ‘500’ jumped an average 15.3% and rose in price 94% of the time.” Before you get too excited, just remember that trends continue until they don’t.

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AAII Sentiment Survey

Optimism remained near 50% as many individual investors are encouraged about the short-term outlook for stock prices, according to the latest AAII Sentiment Survey. Neutral sentiment rose this week, while pessimism declined further.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 0.3 percentage points to 49.4%. Optimism is above its historical average of 39.0% for the fourth consecutive week and the 11th out of the past 12 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 1.7 percentage points to 29.6%. Even with the increase, neutral sentiment remains below its historical average of 30.5% for the fifth time in the past six weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, declined by 1.4 percentage points to 21.1%. This week’s decline puts pessimism at a nine-week low and brings the two-week drop to a cumulative 12.6 percentage points. The historical average is 30.5%.

Bullish sentiment is above 49% on consecutive weeks for the first time since February 3 and February 10, 2011. Even with this week’s decline, optimism remains at unusually high levels (more than one standard deviation above average). Past readings of unusually high optimism have typically been followed by lower-than-average levels of market gains, as I explained in the June 2014 AAII Journal.

Bearish sentiment is near the bottom of its typical range. A drop below 20.5% would put bearish sentiment at an unusually low level (more than one standard deviation below average). In the past, unusually low readings have been followed by modestly lower-than-average six- and 12-month gains in the S&P 500.

As I discussed last week, many individual investors viewed this month’s bout of downward volatility as a buying opportunity. The pullback in the S&P 500 index and the correction in the Russell 2000 index made valuations more attractive and helped to alleviate concerns about stock prices having moved too far upward too fast. Also contributing to the level of optimism are earnings growth, sustained economic expansion and the Federal Reserve’s tapering of bond purchases. Keeping some AAII members cautious are worries that a larger drop in stock prices is forthcoming, a sense that prevailing valuations are still too high, geopolitical events, the pace of economic growth and Washington politics.

This week’s special question asked AAII members what type of candy they will be giving out to trick-or-treaters tomorrow night, Halloween. Just under 40% of respondents said they will give out an assortment of chocolate, candy bars or other candies. Snickers will be the treats offered by about 14% of respondents. Nearly 7% will pass out lollipops or Tootsie Roll Pops. A little more than 20% said they won’t be handing out candy, primarily because they are not expecting any children to stop by tomorrow night.



This week’s Sentiment Survey results:

Bullish: 49.4%, down 0.3 points
Neutral: 29.6%, up 1.7 points
Bearish: 21.1%, down 1.4 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!