A Balanced Portfolio for a Balanced Life

Fear gripped the financial markets five years ago as the U.S. and the world suffered through the worst global economic downturn since the Great Depression. Millions of individual investors sold stocks and mutual funds during the crisis and continued liquidating through 2012 for fear of another downturn.

Yet on Friday, January 26, 2013, the Wilshire 5000 Index hit an all-time record high, breaking through the previous record set on October 9, 2007. This proxy of the total U.S. equity market, which includes large companies and small, was up 131.52 percent or $10.8 trillion from the low on March 9, 2009. This gain doesn’t include dividends or dividend reinvestment over the period.

Investors that sold during the crisis and stayed out have missed a precious opportunity to recover their losses and earn respectable profits in the stock market. These opportunities don’t come often and they certainly will not come as easy in the future.

There were many individuals who managed well during the market collapse and its subsequent recovery. I’m not talking about the Wall Street bankers who made millions in golden parachutes or a select group of hedge fund managers who shrewdly shorted sub-prime mortgages. I am speaking of average investors who did an above-average thing during the financial crisis – they didn’t panic. Instead, they maintained their discipline and held a balanced portfolio of stocks and bonds.

The buy, hold and rebalance approach to investing is one of the simplest and most effective ways to diversify and prosper in the financial markets over the long-term. A portfolio is allocated based on each investor’s needs across different asset classes such as stocks, bonds and real estate. The portfolio mix is maintained periodically using rebalancing.

Winning investments are pared back and underperforming investments are increased during a rebalancing. A rebalancing can occur on a specific date, such as a birthday or anniversary, or it can be done using a percentage of asset method. See my book, All About Asset Allocation for a detailed discussion of rebalancing techniques.

Figure 1 is an illustration of rebalancing using a 50% stock and 50% bond allocation. When stocks gain versus bonds, the percentage becomes too large. Shares of the stock investment are sold and the proceeds are reallocated to bonds. This serves as a risk control mechanism for the portfolio.

Figure 1: Rebalancing a 50% stock and 50% bond portfolio

Portfolio Rebalancing

Source: Morningstar Principia

Figure 2 illustrates the returns of a portfolio allocated to 50 percent in stocks and 50 percent bonds. The proxy for stocks is the Vanguard Total Stock Market Index Admiral Shares (ticker: VTSAX) and the proxy for bonds is the Vanguard Total Bond Market Index Fund Admiral Shares (ticker: VBTLX). Both funds hold broad representations in their respective markets. The beginning date was October 1, 2007 and ending date was Friday, January 25, 2013. The 50/50 portfolio was rebalanced annually at the beginning of each calendar year.

Figure 2: Comparing a 50/50 Portfolio to Each Fund


Source: Vanguard

Figure 2 shows that the 50/50 diversified portfolio isn’t quite matching the 100 percent bond portfolio just yet, but we’re getting close.  Every stock investor lost money during the crushing bear market that began in October 2007. Prices were down nearly 60 percent from peak to trough. A 50 percent stock and 50 percent bond portfolio was down about 25 percent at its lowest point. Even a portfolio holding only 20 percent in stocks didn’t escape the bear and was down about 5 percent by the time the market hit bottom in March 2009.

Ideally, our crystal ball would have told us to get out of stocks before the crisis, but realistically no one knows what the market is going to do in the future. We invest in stocks because in the long-term the returns are substantially better than bonds. We need this growth just to stay ahead of inflation and taxes. Patience is a virtue, though. Bear markets occur unexpectedly and only those with disciple are rewarded.

Many financial pundits criticize a balanced approach. They say a buy, hold and rebalance strategy is simple-minded and a relic of the past. Their solution is to be tactical, meaning aggressively move in and out of the markets. As it turned out, more than half the experts fail to time markets correctly and their portfolios have fallen short of the simple strategy they mock so much.

Balanced investing is part of a balanced life. A buy, hold and rebalance strategy using broad market index funds is one of the simplest and most effective ways to diversify and prosper over the long term. It helps keeps us sane and our portfolios healthy during good times and bad.