How rebalancing works

What Joan should’ve done once a year or so was to rebalance her portfolio so that the initial “60/40” (stock/bond) mix was reset. She should never have allowed any one slice of her portfolio to overtake the rest. She should’ve periodically pulled her portfolio back into balance.

To illustrate how this should be done, I’ll use the simple middle-of-the-road ETF portfolio that I introduce in Chapter 21. At the start of the year, the portfolio is just where you want it to be: 60 percent diversified stocks, 40 percent bonds. But it turns out to be a banner year for stocks, and especially for small-cap U.S. stocks. At the end of the year, as you can see in Table 23-1, the portfolio looks quite different.

What to do? Bring things back into balance, starting with the bond position. That’s because the split between stocks and bonds has the greatest impact on portfolio risk. In this example, you need to increase the bond allocation from 32 percent back up to 40 percent. If you have a year-end portfolio of $100,000, that means you’ll buy $6,000 in municipal bonds to bring that allocation up to $30,000 or 30 percent of your portfolio. You’ll also buy $1,000 of the BNY Mellon Core Bond ETF and $1,000 of the Vanguard Total International Bond Index ETF, so that your taxable bonds will be back to $10,000 total, or 10 percent of the portfolio.

Where will the $8,000 come from? That depends. You could sell off part of your stock position, which may be necessary given that things are pretty seriously out of balance. But do keep in mind that selling off winning positions in a taxable account will require you to pay capital gains — and possibly a small commission on the ETF trades. So to the extent possible, try to rebalance by shoring up your losing positions with fresh deposits or with dividends and interest earned on your portfolio.

How often to rebalance

The question of how often to rebalance has been studied and restudied, and most financial professionals agree that once a year is a good timeframe, at least for those still in the accumulation phase of their investing careers. Anything less frequent than that increases your risk as positions get more and more out of whack. Anything more frequent than annually, and you may lower your returns by interrupting rallies too often and increasing your “friction” costs (spreads, possible commissions, and taxes).

Keep these costs in mind as you rebalance. Tweaking a portfolio by a few dollars here and there to achieve “perfect” balance may not make sense.

Another way to approach rebalancing is to seek to address any allocations that are off by more than 10 percent, and don’t sweat anything that’s off by less. In other words, if your muni-bond position is given an allocation in the portfolio of 30 percent, I wouldn’t worry too much about rebalancing unless that percentage falls to 27 percent or rises to 33 percent.

Rebalancing for retirees

If you are in the decumulation phase of your investing career (that’s a fancy way of saying that you are living off of your savings), you may want to rebalance every 6 months instead of 12. The reason: Rebalancing has a third purpose for you, in addition to risk-reduction and performance-juicing. For you, rebalancing is a good time to raise whatever cash you anticipate needing in the upcoming months. In times of super-low interest rates on money market and savings accounts, such as we’ve seen in recent years, it can be profitable to rebalance more often so that you don’t need to keep as much cash sitting around earning squat. I provide more information on raising cash for living expenses in retirement in Chapter 24.

Understanding the all-important P/E ratio

I talk about reversion to the mean in Chapter 22. If a certain asset class has been seeing returns much, much lower than its historical average, you may want to very slightly overweight that asset class. If, for example, you are considering overweighting U.S. stocks, it makes more sense to do it when U.S. stocks are selling relatively cheaply. Typically, but not always, an asset class may be “selling cheap” after several years of underperforming its historical returns.

But is there any way to find a more objective measure of “selling cheap”? Investment legend Benjamin Graham liked to use something called the P/E ratio. The P stands for price. The E stands for earnings. When the market price of a stock (or all stocks) is high, and the earnings (or profits for a company or companies) are low, you have a high P/E ratio; conversely, when the market price is down but earnings are up, you have a low P/E ratio. Graham, as well as his student Warren Buffett, preferred to buy when the P/E ratio was low.

Throughout Part 1 of this book, I urge you to consider tilting your entire stock portfolio, on a permanent basis, toward lower P/E stocks, otherwise known as value stocks. Here, I’m talking not about a permanent tilt but a mild, temporary one. It stands to reason that if value stocks outperform other stocks — and historically, they have done just that — and if the entire stock market appears to be a value market, then that market may outperform in the foreseeable future.

Work by Yale University economist Robert J. Shiller has lent credence to the notion that buying when the P/E ratio is low raises your expected returns. In fact, Shiller has tinkered with the way the P/E ratio is defined so that the earnings part of the equation looks back over a decade (rather than the typical one year) and then factors in inflation. Shiller’s research, based on tracking market returns with varying P/E ratios over the decades, indicates that when his adjusted P/E ratio is low, the stock market is more likely to produce gains over the following decade. When the P/E ratio is high (it reached an all-time high in 1999, for example), you may be looking forward to a decade of very low (or no) returns. Sure enough, the first decade of the millennium produced a rather flat market.

Applying the ratio to your portfolio

Although Shiller’s theories have been debated, it stands to reason that, if they are applied carefully, you may just do yourself a favor to slightly overweight all stocks when the P/E ratio is low and to underweight all stocks when the P/E ratio is high. But against the probability that Shiller’s formula holds, you need to weigh the very real transaction costs involved in shifting your portfolio. On balance, I wouldn’t suggest engaging in tactical asset allocation very often…and then only if the numbers seem to be shouting at you to act.

One very quick way to check the P/E ratio for the entire stock market would be to look up an ETF that tracks the entire market, such as the Vanguard Total Stock Market ETF (VTI), on Vanguard’s website (www.vanguard.com) or on just about any financial website (such as www.morningstar.com). Or, to see both the traditional and the potentially more powerful “Shiller PE Ratio,” go to www.multpl.com. (The P/E ratio is sometimes called the “multiple.”)

The historical average for the S&P 500 P/E Ratio is about 16. It is now roughly 34. The historical average for Shiller’s adjusted P/E is about 17. It is now 38. So, unless those numbers have changed by the time you’re reading this chapter, you don’t want to overweight stocks right now. However, if stock prices should fall and earnings should rise, and you start to see the P/E fall back to historical norms or below, you may want to gently — very gently — tweak your portfolio toward the more aggressive side.

Did I remember to say ‘gently’?

If, all things being equal, you determine that you should have a portfolio of 60 percent stocks, and if the adjusted P/E falls to the low teens, then consider adding 2 to 3 percentage points to your stock allocation, and that’s all. If the market P/E falls to 14 or less, then maybe, provided you can stomach the volatility, consider adding yet another percentage point or two, or even three, to your “neutral” allocation. If the adjusted P/E rises back up to where it was in 1999 — about 44 — then you may want to lighten up on stocks by a few points. Please, keep to these parameters. Tilting more than a few percentage points — particularly on the up side (more stocks than before) — increases your risks beyond the value of any potential gains.

Buying unloved assets

Ever notice how weeds grow so much faster than the plants that you want to see grow? For years, since 1994 in fact, Morningstar has advocated, and continues to advocate, something called “Buy the Unloved.” It calls not for overweighting asset classes that sport low P/E ratios, but for overweighting asset classes that investors (being the lemmings that they are) have abandoned in droves. In other words, you are encouraged to buy “weeds.”

Morningstar’s “weed-buying” strategy has been very successful. (I’m not providing specific performance numbers because they are clouded by Morningstar’s use of actively managed funds to amass the weeds.) Morningstar also cautions that weed-gathering should not be used as a stand-alone strategy. And I agree.

But before you decide to underweight or overweight any part of your portfolio, I would advise quickly checking fund flows. I just typed the words “fund flows 2021” into my search engine, and a number of sources popped up. I found data from Morningstar, BlackRock, Fidelity…

I can see that in the first half of 2021, a whole lot of people (including me) started to buy value stocks and abandon growth. They (like me) have been looking at the nosebleed P/E ratios of growth stocks, and how value stocks look so good in comparison, and they’ve been acting accordingly.

What this information tells me is that I’m not so brilliant or unique as I thought! Yes, I still want to be overweighted in value, but given the fund flows into value over these past months, I’m going to temper my enthusiasm and keep my value tilt a bit lighter than I otherwise might have.

What the heck is “substantially identical” anyway?

The IRS rules are a bit hazy when it comes to identifying “substantially identical” investments. Clearly, you can’t sell and then buy back the same stock. But if you sell $10,000 of Exxon Mobil Corp. (XOM) stock, you can buy $10,000 of an ETF that covers the energy industry, such as the Energy Select Sector SPDR (XLE) or the Vanguard Energy ETF (VDE). They’re not the same thing, for sure, but either one can be expected to perform relatively in line with XOM (and its competitors as well) for the 30 days that you must live without your stock. And rest assured, no ETF could reasonably be deemed to be “substantially identical” to any individual stock.

I, of course, would prefer that you keep most of your portfolio in ETFs in the first place. Even then, if you follow my advice, and one year turns out to be especially bad for, say, large-cap value stocks, no problem. If you are holding the iShares S&P 500 Value Fund (IVE) and you sell it at a loss, you can buy the Vanguard Value ETF (VTV), hold it for a month, and then switch back if you want.

Two ETFs that track similar indexes (IVE tracks the S&P 500 Value Index; VTV tracks the CRSP US Large Cap Value Index) are going to be very, very similar but not “substantially identical.” At least the IRS so far has not deemed them substantially identical. But the IRS changes its rules often, and what constitutes “substantially identical” could change tomorrow or the next day. It’s usually a good idea to consult with a tax professional (which I am not) before proceeding with any tax harvesting plans.

Betsy and Mark: A fairly typical couple

Betsy and Mark are just married. They don’t have a lot of money. But both are young (early 30s), in good health, gainfully employed, and without debt. They plan to merge their combined savings of roughly $41,500 and asked me to help them invest it for the long haul.

The first thing we do is to decide how much money to take out to cover emergencies. Given their monthly expenses of roughly $3,500, we decide to earmark five months’ of living expenses — $17,500 — and plunk that into an online savings account. That leaves us with $24,000 to invest.

This $24,000 is money they tell me they shouldn’t need to touch until retirement. I urge them both to open a Roth IRA. (Any money you put into a Roth IRA grows tax-free for as long as you want, and withdrawals are likewise tax-free; more on retirement accounts in the next chapter.) I ask them to divide the $24,000 between the two accounts. Because each of them can contribute $6,000 per year, I have them both make double contributions — one immediate contribution of $6,000 each for the current year (they can make their 2021 contributions until April 15, 2022), and one contribution each for 2022. (They’ll have to hold the second $6,000 each in cash until the morning of January 1, 2022.)

To keep things simple for now, because the couple has no investment experience, I limit the number of investments. The only difference: Mark tells me he wants to be as aggressive as can be, whereas Betsy is more ambivalent about taking a lot of risk. With this in mind, I give Mark greater exposure to stock, and less to bonds. I also give Betsy more stock than bonds, but less than I give Mark.

As Betsy and Mark’s portfolio grows, I would plan to add other asset classes (real estate investment trusts, inflation-protected securities, and so on) and other accounts.

One year later

Betsy is pregnant with twins! The couple is saving up for their first home, with a goal of making that purchase within 18 months. Although IRAs are normally not to be touched before age 59½, an exception is made for first-time home purchases. Betsy and Mark could take out as much as $10,000 from each Roth IRA without having to pay either a penalty or tax on the gains.

I’d rather that they leave their Roth IRA money untouched, but the couple informs me that they think the money may need to be tapped. At this point, the money in each of the two Roth IRAs has grown from $12,000 to $14,000 each (for illustration purposes, I’m pretending that each investment grew by an equal amount), and Betsy and Mark can each contribute another $6,000 in fresh money, bringing the total of each account to $20,000. Because there is a possibility that $10,000 from each account may need to be yanked in one year, I decide to earmark most of the fresh money to a fairly nonvolatile short-term bond ETF.

Yet one year later

The twins (Aiden and Ella) have arrived! Much to their surprise, Betsy’s parents have gifted the couple $10,000 for the purchase of their home. The Roth IRA money needn’t be touched. At this point, I would sell the short-term bond fund and add to their other positions. Also, provided the couple had another $6,000 each to contribute, I’d begin adding asset classes to the mix, perhaps introducing a Treasury Inflation-Protected Securities (TIPS) ETF, and a REIT ETF. If there’s money left over to invest in a taxable brokerage account, I might add a tax-free muni ETF.

Hopefully, Betsy and Mark (and Aiden and Ella) will have many happy years together. And with each major life event, I would urge them to adjust their portfolio appropriately.

Understanding puts and calls

All kinds of options exist, including options on options (sort of). The derivatives market almost seems infinite — as does the number of ways you can play it. But the two most basic kinds of options, and the two most popular by far, are put options and call options, otherwise known simply as puts and calls. I’m going to take just a moment to describe how these babies work.

Using options to make gains without risk

Those people who use calls as an investment (as opposed to gambling) strategy are assuming (as do most investors) that the market is going to continue its historical upward trajectory. But instead of banking perhaps 60 or 70 percent of their portfolio on stocks, as many of us do, they take a much smaller percentage of their money and buy calls. If the stock market goes up, then they may collect many times what they invested. If the stock market doesn’t go up, then they lose it all — but only a modest amount. Meanwhile, the bulk of their money can be invested in something much less volatile than the stock market, such as bonds.

Zvi Bodie, Professor of Finance and Economics at Boston University School of Management, wrote a book with Michael J. Clowes entitled Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals (Prentice Hall) in which he suggests an investment strategy using long-term stock options and Treasury Inflation-Protected Securities (TIPS). If you have $100,000 to invest, says Bodie, then you might consider putting roughly 90 percent of it into TIPS. (A very convenient way to do that would be to purchase the iShares Barclays TIPS Bond Fund ETF.) That way, he asserts, your principal is protected.

To shoot for growth, says Bodie, take the other 10 percent or so and invest it in long-term call options (otherwise known as Long-Term Anticipation Securities or LEAPS), going about three years out. If the market soars, you take home the bacon. If, however, the market sinks, your call options merely expire, and you still have your TIPS, which by this point, three years later, have grown to match your original $100,000.

It’s an intriguing strategy that just may make sense, especially for older investors tapping into their savings who can’t wait for the stock market to come back after a serious bear market.

Interestingly, a similar kind of “worry-free investing” may be achieved by owning all stocks (or close to it) but using put options to protect yourself from the downside. Certain “inverse” ETFs exist that should, in theory, allow you to achieve the same end. However, as I discuss in Chapter 20, these funds haven’t worked so well in the real world.

Insuring yourself against big, bad bears

The put option is an option to sell. This investment strategy allows you to have money in the stock market (all of it, if you so desire), but you carry insurance in the form of puts. If the market tumbles, you’re covered.

Suppose you want to invest everything in the NASDAQ index through the QQQ. Normally, an investor would have to be insane to bet everything on such a volatile asset. But with the right put options in place, you can actually enjoy explosive growth but limit your losses to whatever you want: 5 percent, 10 percent, 15 percent.

With a pocketful of puts, you can laugh a bear market in the face. If the QQQ drops by, say, 50 percent in the next week, you will have checked out long before, smiling as you hold your cash.

Seeming almost too good to be true

So options allow you to capture the gains of the stock market with very limited risk. They allow you to invest in the market and not have to worry about downturns. What’s not to love about options?

Whoa — not so fast! You need to know a couple little things about options:

• They are expensive. Every time you buy either a put or a call, you pay. The price can vary enormously depending on the strike price, the expiration date you choose, and the volatility of the ETF the option is based on. But in no case are options cheap. And the vast majority of options reach their expiration date and simply expire.

  So, yes, options can save you in a bear market, and they can help you to capture a bull market, but either way, you’re going to pay. Free lunches are very hard to come by!

• If you happen to make a gain on an option, the income will usually be considered a short-term gain by the IRS. As such, you may pay twice the tax on it that you would on the long-term appreciation of a stock.

Weighing options strategies against the diversified ETF portfolio

Don’t misunderstand me. I’m not saying that the price you pay for options isn’t worth it — even after taxes are considered. Options do provide investors with a variety of viable strategies. The real question, though, is whether using puts and calls makes any more sense than investing in a well-diversified portfolio of low-cost ETFs. Most financial professionals I know are skeptical. And that includes several who have traded heavily in options only to learn the hard way that it is a very tricky business.

To be sure, if I knew a bear market were coming, I would definitely buy myself a slew of put options. If I knew a bull market were in the offing, I would certainly buy a fistful of call options. But here’s the problem: I don’t know which way the market is going, and neither do you. And if I buy both puts and calls on a regular basis, I’m going to be forever bleeding cash.

Not only that, but if the market stagnates, then both my puts and calls will expire worthless. In that case, I’m really going to be one unhappy camper.

So here’s the way I look at it: The chances of success with a steady call strategy are one in three: I win if there’s a bull market; I lose if there’s a bear market; I lose if the market stagnates. Ditto for a put option strategy: I win if there’s a bear market; I lose if there’s a bull market; I lose if the market stagnates. It’s hard to like those odds.

With a well-diversified portfolio of low-cost ETFs — stock, bond, REIT ETFs — I reckon my chances of success are more like two in three: I lose if there’s a bear market; I win if there’s a bull market; in the case of a stagnant stock market, something in my portfolio will likely continue to make money for me anyway.

You may recall my saying earlier in the chapter that the derivatives market almost seems infinite, as does the number of ways you can play it. If you want, ETF options strategies exist that allow you to make money in a stagnant market, too. The most common such strategy is called a buy-write strategy or selling a covered call. I explain how that strategy works (but don’t necessarily advocate it) in the sidebar, “How to profit with ETF options in a stagnant market.”

Factoring in time and hassle

One final (but fairly major) consideration: Options trading generally requires much more time and effort than does buy-and-hold investing in a diversified portfolio. Let me ask you this: Would you rather spend your spare time at your computer tinkering with your investments, or would you rather do just about anything but that?