Rebalancing, The Forgotten Facet Of The February Four

We are now entering the last week of February, the month known for four things: the Super Bowl, Groundhog's Day, Valentine's Day and rebalancing.  Rebalancing?  What's that?  Rebalancing is the exercise you should all be doing once a year to make sure that the retirement savings you've accumulated are being maintained in the proportions you have earlier decided are the correct ones for you.  If you don't rebalance, it is easy for your savings to become furtively unbalanced, and that would be a bad thing.  To be honest, the important thing is to rebalance annually.  The month in which you choose to do so is not so important, as long as it's the same month each year.  I prefer February, as explained in Section VI below.

I. What it means.  Let's say that after consulting your Uncle Hubert, reading tea leaves, discussions with the boys and girls around the water cooler, throwing darts at a board and perusing the Wall Street Journal, you have decided that the percentages your retirement savings should "be in" are 70% stocks, 20% bonds and 10% cash.  Stocks, bonds and cash are the three main categories of most retirement portfolios.  (Others might include real estate, commodities and alternative investments, but for purposes of this post we are only going to consider the main three.)  The percentages you choose will be based on a number of factors, including your age and your risk tolerance.  If you start out the twelve month period with $10,000 in savings, the 70-20-10 ratio you chose would result in you having approximately $7,000 invested in stocks, $2,000 invested in bonds, and $1,000 in cash.

Now let's say that the stock market has a banner year, and your stock portfolio grows by 15%, while the bond portion dips 10% and cash portion of your savings remains stagnant throughout your selected twelve month period.  You now have $8,050 in stocks, $1,800 in bonds, and $1,000 in cash, for a total of $10,850.  But what has happened to the 70-20-10 allocation you so carefully had decided was right for you?  It now looks like this:  74.2% stocks, 16.6% bonds and 9.2% cash.  There are worse things in the world than having your allocation out of whack by just a few percentage points, such as in the foregoing illustration, but a preferred discipline is to do an annual rebalancing anyway.  The older you get (or put another way, the closer you get to when you'll need your money) and the more money you have saved, the more important rebalancing to your desired allocations becomes.  Your immediate goal (subject to what I've written in Section V below) should be to get back to the allocation you started with for that period.  That's what is known as "rebalancing."

II. Why bother?   There are at least two reasons why taking the time to rebalance annually is worth your while.  First and foremost is risk management.  Do you remember the term "false prophets" being used in the Bible?  There are also false prophets in the investment world.   Don't believe anyone who claims she can "time the market."  That person is the modern day version of a false prophet.  Any time you invest in anything other than cash or federal government securities, you are taking a risk.  But if cash and fed securities were all we invested in, we would never make any real money.  In fact, if you take inflation into account, you'd be losing money (buying power) in some years.  The only way for most folks to make real money with their investments is in the stock market, either by being a picker of individual company stocks, or by investing in one or more mutual funds which concentrate on stocks (sometimes called equity funds).  Of the three main categories identified in Section I, stocks have, by far, the most upside potential, but also carry the most risk.  So, when we set our desired allocation percentages for the year, we are managing how much risk we are willing to take.  The higher the allocation for stocks, the more risk we are taking.  The percentages we set at the beginning of the annual period should not be drastically different from those we had set at the start of the immediately preceding period.  Thus, if we started out Year 1 with a stock allocation of 70% and end up with 74.2%, we should probably scale down our risk to something closer to that 70% for the beginning of Year 2.  (Note: Some gurus' advice is to wait until one of your portfolio's components gets seven to ten percent away from your desired allocation before rebalancing.  I do not agree with that approach because it's too easy to put your savings on automatic pilot and do nothing.  Inertia is a powerful force.)

It has often been said that the best advice one can receive regarding investing in the stock market is to "buy low and sell high."  Ah, yes, if only it were that easy!  But you don't know exactly when a stock which you'd like to buy is going to hit its nadir, nor do you know exactly when a stock you're willing to sell will hit its peak.  Remember, no one knows for sure how to time the market.  That gets us to our second reason why an annual rebalance is a good thing:   It forces you to buy low and sell high.  This concept is often overlooked when financial columnists write about rebalancing, probably because of risk management (the reason discussed in the immediately preceding paragraph) being so important.  If you need to trim, say, 4.2% of your stock holdings to get back to your desired allocation percentage, simply pick the stock(s) that has been the best performing and you will undoubtedly be selling high.  (Now is a good time to relay to you some advice I received from a trusted financial advisor:  Once you sell, don't look back!  In other words, if you sell a stock and the next day its price goes up, don't kick yourself.  No one can time the market! (There, that's the third time I've written that!)  Do a good job deciding which stock to sell, and then once you do, be confident you made a smart choice no matter what transpires down the road.)

The same general idea follows if you need to buy in order to rebalance.  Using our original example, if you need to buy bonds (or mutual funds which concentrate on bonds) to get back up to the desired 20% allocation, there is a good chance the bond market is down.  (Otherwise your bond portfolio may not have shrunk.)  That is the time to buy bonds rather than when bonds are soaring.

III. How to rebalance.  There are two ways rebalancing can be accomplished.  The most common way is what I've already described above.  You can sell the assets in those categories which have an excess allocation, and use the proceeds to acquire assets in the categories which have a deficit allocation.  If cash is a deficit category, then the proceeds from the sale of surplus categories would simply sit as cash.  After consummating these sell and buy transactions, the aggregate amount of money in your overall portfolio will be roughly the same as before your rebalancing transactions.

The second way to rebalance is to use new money to bolster your deficient asset categories by buying assets of that type, without selling assets from your surplus categories.  "New money" can include a redirection of dividends and/or interest generated from assets already in your portfolio.  Obviously, "new money" can also mean money which is not currently connected to your portfolio, such as money from future pay checks, an inheritance or winning the lottery.  Also obvious is that rebalancing with new money results in the aggregate amount of your overall portfolio being greater than before you rebalanced.

Some financial institutions offer automatic rebalancing for their clients.  I don't have a problem with that although I would have two words of caution.  First, don't opt for more than an annual rebalance.  Anything more frequent is sheer falderal, and could make the fees associated with your retirement account(s) higher.  Second, if you do opt for auto-rebalancing, make sure you understand how the rebalancing is accomplished.  You may someday have your money with an institution where the auto-rebalance is not offered, so you need how to DIY if need be.

IV. Choosing the right account.  When you decide the percentages in which your retirement funds shouId be allocated, you must take into consideration the funds in all of your retirement accounts, including pre-tax accounts (e.g., 401(k), 403(b) or traditional IRA), taxable accounts (e.g., a brokerage account) and Roth accounts.  If you have more than one of those types of retirement accounts, when it comes time to rebalance you will be faced with the decision of which of them to choose for said rebalancing.  It almost always makes the most sense to choose the account for which the sale of an asset will not, of itself, trigger an immediate taxable event.  For example, if you sell appreciated stock out of a traditional IRA, and kept the sale proceeds within that account, there would be no immediate tax impact.  You don't pay taxes on traditional IRA funds until they are withdrawn (which, ideally, would be after you retire).  Contrast that with what happens when you sell appreciated stock out of a brokerage account.  That is a taxable event, meaning that you will pay taxes on the gain at the end of the current tax year.  (Gains made from the sale of securities in a taxable account are taxable, either at capital gains or ordinary income rates, depending on how long you've own the security prior to unloading it.)

V. Selected ratios are not static.   One point of clarification with respect to the second-to-last sentence of Section I.  The desired allocation percentages you choose will change over time.  Conventional wisdom dictates that the older you get, the more you should rein in your riskier investments.  Some people might change their percentages every year. For example, a thirty year old might have 80% of her retirement funds in stocks, then ratchet it down to 79% for the year in which she turns age thirty-one.    When you rebalance at the start of a given year ("Year 2"), the percentages you hope to reach via rebalancing should be those you've selected for Year 2, which may be different from those you had selected for Year 1.

VI. A plug for February.  I select February as my rebalancing month mostly because (i) it is near the beginning of the calendar year, and I like to have all my ducks in a row for the year, (ii) January tends to sneak up on people, and having a goal of rebalancing in January might prove to be a little too optimistic or aggressive (similar to keeping New Year's resolutions), (iii) I like to reserve the month of March for working on my taxes, or at least accumulating and organizing my documents, and (iv) February is a relatively boring sports month, so the time it takes to do the rebalancing exercise is not pulling me away from ESPN-watching.

VII. A bad scenario.  In case you're on the fence regarding whether you want to bother yourself with rebalancing, let me try ending this post with a horror story.  Don't be the guy who, for his entire working life, has never rebalanced.  His stock portfolio has reached 85% of his total retirement portfolio.  But at age sixty, the market takes a precipitous fall, and a long-term bear market begins.  His portfolio worth is a shadow of its former self.  Because of his age, he has little time to recoup (aka, a short investment horizon) to build his account back up to being close to what it was before the crash.  Had he rebalanced, and made the types of adjustments described in Section V, he would not be in this pickle.

You only go around once. Play it smart, and rebalance annually.

The Case Of The Clawback Crusader

While our country awaits the decision of the US Supreme Court in the so-called Obamacare case, there is another fascinating legal battle going on right here in Minnesota.

Imagine that you are the pastor of a medium size congregation on the outskirts of the Twin Cities metro area. Every year the population of your town is increasing, and with that trend comes a growth spurt for your congregation and the need to expand your facilities. You and your parishioners pray that you will find the means to make that expansion happen, and soon thereafter a donor comes forward with a six or seven figure check. Plans are drawn, a new addition (perhaps a community center where seniors can gather, or a pre-school and day care facility) is constructed, and your building is no longer overcrowded. You feel blessed, and lucky. But, several years later you learn that the donor was a major Ponzi scheme operator, and that the funds he gave you were tainted. Now the government wants you to return that money. Since the money is already spent, in the form of bricks and mortar, that just might be kind of hard to do.

In a different scenario, imagine that years ago you invested most of your life's savings with that same Ponzi schemer, thinking that not only would your money be safe but that you would earn a decent return on your investment. Now your money, along with funds entrusted with that schemer in good faith by hundreds of other innocent people like yourself, has vanished. The money that all of you thought was being invested was actually spent either to support the extremely lavish personal life style of the Ponzi artist, or to pay off people who unwittingly invested before you did.

The two situations described above are not uncommon in the aftermath of the Tom Petters scandal which rocked Minnesota when it first came to light four years ago. By way of background, a Ponzi scheme entails an investment of funds by an initial group of innocent people who are led to believe that the person with whom they are investing will, in turn, reinvest their funds on the individuals' behalf. But instead of making those investments that the Ponzi artist has described to the individuals, he uses the money for other purposes, such as funding his own personal expenses or putting the money in a different investment vehicle than the one promised. Meanwhile, the artist concocts phony statements which look like the real McCoy to the unsavvy investors, with those statements showing a much more handsome rate of return than those people could get anywhere else. Hardly any of the original investors ask to cash out, because they have been led to believe, via verbal assurances and the phony statements, that they are making money hand over fist. In the unlikely event that an original investor does want out, the funds for liquidation come from a second wave of innocent investors. In other words, the first investors are being paid with the seed money invested by the second investors, and so on down the line.

In the Petters' racket, he created phony statements showing investment in goods which, he said, were being sold as inventory to big box retailers such as Best Buy. By the time his accomplice, Deanna Coleman, ratted on him to the US Attorney's office, Petters' Ponzi scheme had resulted in $3.65 billion (that's with a "b") worth of investments made by unsuspecting individuals going down in flames. There was no contract with any retailer. Petters was found guilty and was sentenced to fifty years (compared to Coleman's slap on the wrist of a one year sentence). Petters' companies were forced into bankruptcy, which is under the jurisdiction of the federal court. The court has appointed Doug Kelley, whom I have dubbed "the Clawback Crusader," as the trustee in bankruptcy.

As in any bankruptcy, the job of the trustee is to try to make the pot of dough for the unsecured creditors of the bankrupt debtor as large as possible. One of the tools available to the trustee is the clawback procedure. In a clawback, the trustee forces the recipients of so-called "ill gotten gains" from the debtor to return the money to the court, via the trustee. The theory behind the clawbacks is this: the money obtained in good faith by the unsuspecting party (such as the congregation in my first scenario above) from the bad guy was not his to give in the first place. As cold as that seems, Kelley's argument is that permitting the non-profit recipients to keep the money donated to them by Petters would be unfair to the folks who got screwed by Petters, such as the investors in my second scenario above. Kelley estimates that the amount of money he's targeting for clawbacks is $425 million! At the end of the day (if you can stand that cliche), either the congregation will have to somehow find a way to give the Petters donation back, or the original investors will be left out in the cold, with none of their investments salvaged.

This week, the Minnesota state legislature passed a bill giving the non-profits a huge break. Under the newly passed law, non-profits would only be subject to the trustee's clawback with respect to those funds received from the debtor (in this case, Petters) within two years of the clawback demand. Any funds received further in the past could be kept. (The old law was a six year statute of limitations.) Governor Dayton signed the bill into law, over the dramatic objections of Kelley. Kelley has yet to announce if he will appeal.

The new law obviously works to the severe detriment of the investors. The money which trustee Kelley will be able to recoup for them under the clawback will be significantly less, because Petters made almost all of his donations to the non-profits more than two (but less than six) years ago. Most of those donations were subject to the clawback under the old law, but not under the new one. Conversely, many of the non-profits, such as Minnesota Teen Challenge, Big Brothers And Big Sisters Of The Twin Cities, and the College Of St. Benedict, praised Dayton and the legislature. For now, they can breathe a sigh of relief.

The fact that I was a not a bankruptcy lawyer does not stop me from making a prediction here. If Kelley appeals, I believe he has a better than even chance of getting the new law overturned on the grounds of it being unconstitutional. In my view, the investors have a better claim to those funds than do the non-profits, notwithstanding the fact that the non-profits have long-since spent the money. Additionally, I question whether Minnesota lawmakers can pass such a law retroactively. The rules of the game (reducing the statute of limitations from six years to two) should not be changed after the horse is already out the barn door. Finally, the Bankruptcy Code is a federal law, and if a conflict is deemed to exist between federal and state law, the bigger boys are going to prevail.

Whether or not my prediction proves accurate, this is a very sorry state of affairs. It is impossible for both the non-profits and the investors to win. They are both victims, but one of them will be the much bigger loser.

Laddering CDs

In my January 24 post ("Cash: The Least Sexy Part Of Your Portfolio"), I wrote about the various reasons why you might want to make cash a certain percentage of your investment portfolio, after taking into account your investment objectives and your tolerance for risk, among other things. Once you have settled on an amount for the cash portion, you typically have the option of putting the cash in a money market account, a government issued short-term security or a short-term certificate of deposit (a "CD"). All three can function as cash. This post addresses the issue of how to build a ladder for the chunk you're putting into CDs, particularly an initial mixture of short-term and mid-term CDs.

A CD is akin to a contract between you and a financial institution (the "Bank"), whereby the Bank agrees to pay you a little bit higher rate of interest on the amount deposited than it would be willing to pay on a regular savings account, provided you agree to keep that deposit untouched for a certain period of time. It is almost always true that the longer the term of the CD, the higher the applicable rate of interest. If you decide to "break the contract" by pulling your money out before the end of the term, you are assessed a monetary penalty. The penalty usually equals about 10% of the amount withdrawn. As you can see, therefore, an individual who is considering CDs has to balance the desire for a higher rate which usually comes with a longer term CD against its illiquidity. Because of the illiquid nature of even short-term CDs, a depositor should put some cash aside, apart from the funds going into CDs.

So, now that we've laid the groundwork, how do you set up a ladder? The goal of a CD ladder is to get to the point where you have a three-year (or if you prefer, a five-year) CD maturing every year. That point can be reached in three years, following these steps:

Step 1: Divide the money you are going to use for your CD ladder into three equal lots. With the money in Lot # 1, buy a one-year CD ("CD # 1"); simultaneously, with the money in Lot # 2, buy a two-year CD ("CD # 2"), and with the money in Lot # 3, buy a three-year CD ("CD # 3").

Step 2: After one year (or in other words, at the very beginning of Year # 2), CD # 1 will mature. Take the money from that matured CD # 1 and buy a three-year CD ("CD # 4"). Don't do anything with CD # 2 or CD # 3; they have not yet matured, so let them ride.

Step 3: After another year (or in other words, at the very beginning of Year # 3), CD # 2 will mature. Take the money from that matured CD # 2 and buy a three-year CD ("CD # 5"). Don't do anything with CD # 3 or CD # 4; they have not yet matured, so let them ride.

Step 4: After another year (or in other words, at the very beginning of Year # 4), CD # 3 will mature. Take the money from that matured CD # 3 and buy another three-year CD ("CD # 6"). Don't do anything with CD # 4 or CD # 5; they have not yet matured, so let them ride.

You have no doubt noticed that once you have completed Step 3, you will have a three-year CD maturing every year going forward, and when that happens (i) you take the money from that matured CD and buy a new three-year CD, and (ii) you let your other two CDs ride because they have not yet matured. That, boys and girls, is what we call a "CD ladder." The beauty of a ladder is that you are getting the benefit of a higher rate for a three-year commitment than you would for only a one-year commitment, but you are investing at regular annual intervals instead of three year intervals. As noted above, you could set up a longer-term (say, five-year) ladder instead of a three-year ladder, but then the issue of liquidity merits even more consideration. Plus, it is not always easy to find an acceptable five-year CD.

Two other related items. First, you do not have to buy all your CDs from the same Bank. Check out the website "bankrate.com" for a search of banks offering the best deals. The search can be run locally or nationally. Second, although this is beyond the scope of this post, you should be aware that some investors use the ladder concept for bonds, as those instruments can also be found in terms of different lengths.

Cash: The Least Sexy Part Of Your Portfolio

Other than keeping a rainy day emergency fund in cash equal to about six months of your take home pay, there are a handful of reasons why you might put a stash of cash in your investment portfolio. One would be if you pay attention to the oft-cited principle (the "Rule of 100") that the percentage of stocks and bonds in your portfolio should be equal to the difference of 100 minus your age, with the rest in cash. For example, the theory goes, if you are 35 years old, you should have 65% of your portfolio in stocks and bonds, and 35% in cash (not including the rainy day fund). That is a little too conservative for my taste, but the point is that the older you are, the less time you have to recover from a downslide. Conversely, the younger you are, the more chances you can afford to take, and the more chances you should take. When you are young you have more recovery time from a bear market. The Rule of 100 is especially valid if you start your serious savings during a run of good years, i.e., a bull market, because that kind of market enables you to build up a cushion; a few bad years won't wipe you out. Whether you are young or old, some of your investment picture will include cash.

A second reason for a cash fund, not too much unlike the first, is that you may be running up against a milestone event for which you've been saving, such as a college education for your child, or a graduate degree or retirement date for yourself. If you have been saving for junior's post high school education for the last eighteen years, you don't want that money to disappear right before he goes off to his freshman year at State U. You might be more frisky, investment-wise, when he's in the primary grades, but you should reign it in a little (by allocating more to cash or other safe investments) as he becomes a high school upperclassman.

A third reason for the cash stash might be that you simply have a low tolerance for risk. You just can't get a good night's sleep knowing that the money you have in the market could evaporate in quick order, sometimes due to unforseeable events like economic problems in a small European country (say, Greece, for example) or the bankruptcy of a formerly solid company (like Lehman Brothers). There is nothing wrong with having a low risk tolerance. There are more folks who do than those who admit it. And, those who maintained a high cash position during the most recent recessions looked like geniuses compared to the market players; the former had peace of mind and they did not lose as much moola .

A fourth reason for keeping cash might be that you are holding onto it until you see an investment opportunity for which you can plunk in your dough when the time is right. When shareholders dump some stock, they don't always turn around and immediately reinvest the sales proceeds in some other venture. They might wait for a better opportunity to come along, and in the meantime they keep the proceeds in cash.

The main reason that the typical investor, Mr. Smith, has cash as a definite percentage of his portfolio is that he is hedging his bets. Let's say, for the sake of discussion, that Mr. Jones has all of his money in stocks. If the market goes up he will profit more than Mr. Smith who only had 80% of his money in the market. But if the market goes down, Mr. Jones will lose more than Mr. Smith. I think the trade-off for Mr. Smith is smart. He is not greedy, but by hedging his bet he has a little more peace of mind and can still enjoy the upside, albeit to a lesser degree than Mr. Jones. Yes, this example is a little over-simplified, but it illustrates that cash plays a key role in the investment strategy of the average worker/saver.

If you are convinced that not all of your serious savings should be invested in stocks and bonds, but instead a portion should be allocated to cash, what is the best strategy for doing so? One ploy you might consider is laddering CDs. That will be the topic of my next post.