The stock market experienced a remarkable rise in 2024, leaving many investors celebrating significant gains. However, this surge has prompted a critical examination of investment allocations, as the substantial increase in stock value may disrupt the balance within portfolios. Long-term investment strategies typically aim for a strategic mix of equities and fixed-income securities — commonly 60% stocks and 40% bonds. With the S&P 500 experiencing a staggering 23% increase — the largest two-year cumulative return since the late 1990s — investors now find themselves at a potential crossroads, faced with the need to reassess and possibly rebalance their portfolios.
Market fluctuations can shift an investor’s asset allocation away from their initial target. Financial advisors stress that maintaining the intended balance is essential for risk management. If one asset class, in this case stocks, outperforms others significantly while bonds lag behind, it can lead to overexposure in that winning class, consequently increasing risk. For example, the Bloomberg U.S. Aggregate Bond Index only managed a modest return of about 1% over the past year, highlighting that fixed-income investments fell significantly short in comparison to the stock market. As a result, some investors might find themselves inadvertently holding portfolios that are riskier than their original intended strategy.
Ted Jenkin, a certified financial planner, likens portfolio rebalancing to routine maintenance for vehicles: just as cars require alignment checks, financial portfolios should also be adjusted to realign with investors’ long-term goals. This involves selling a portion of the overperforming asset — in this case, stocks — and reinvesting the proceeds into underperforming assets, like bonds, to restore balance. Such rebalancing serves to mitigate risk and ensure investments align with market expectations and personal financial goals.
To illustrate how rebalancing works, consider an initial portfolio allocation of 80% stocks and 20% bonds. After a vigorous year, this distribution might morph into an unbalanced 85% stocks and 15% bonds. To rectify this, an investor could offload approximately 5% of stocks to restore their intended 80/20 allocation. While this may seem straightforward, the challenge lies in the investor’s willingness to adjust their portfolio amidst fluctuating market conditions.
Furthermore, rebalancing efforts shouldn’t be restricted solely to stocks and bonds. Diversifying across various asset classes is crucial for a well-rounded portfolio. This involves assessing not just overall stock exposure but also delving into specific categories within the stock asset class. For example, just as portfolios may have large, mid, and small-cap stocks, they may also encompass sector-based allocations — a balanced mix of technology, consumer goods, and industrial sectors can further minimize risks stemming from sector-specific downturns.
Amidst these discussions on portfolio adjustments, investors must also be mindful of market disparities, particularly within sectors like technology. Last year witnessed a phenomenon where mega-cap technology stocks, known commonly as the “Magnificent 7” (including giants like Apple, Amazon, and Microsoft), contributed to phenomenal market growth, driving up the S&P 500’s total returns. In contrast, non-U.S. stocks performed poorly with only a 5% return, showcasing stark differences in market performances.
This considerable divergence raises important questions about how much emphasis investors place on high-flying technology stocks within their portfolios. While it’s indisputable that technology thrives in today’s economy, it’s prudent for investors to assess whether they should realize some profits in this sector to mitigate risk exposure. Callie Cox, a financial strategist, suggests that taking profits in high-performing sectors like tech can often be a wise decision while reminding investors that these assets shouldn’t automatically dominate investment portfolios.
Facilitating Efficient Rebalancing
For those enrolled in 401(k) plans, the process of rebalancing has become more seamless thanks to tools that facilitate automatic adjustments. This can significantly relieve the burden on investors who may be unsure about their thresholds for risk or investment timeframes. Additionally, for individuals investing in mutual funds or ETFs, many fund managers regularly perform rebalancing tasks to ensure that their portfolios remain aligned with market targets.
However, it is paramount to remain informed about the potential tax implications that could arise during rebalancing. For taxable accounts, selling assets might lead to capital gains taxes, which could hinder an investor’s overall returns. On the other hand, retirement accounts typically allow for tax-free transactions, thereby providing fewer tax-related concerns as investors navigate the rebalancing process.
While the stock market experiences heady gains, strategic rebalancing remains an essential exercise for maintaining alignment with long-term investment objectives. As investors reflect on their individual situations, conducting periodic checks can ensure that portfolios continue to reflect their underlying financial goals, enabling better risk management amid evolving market landscapes.