Rebalancing Your 401(k)

Rebalancing Your 401(k)

Links Mentioned in this Episode

Complimentary Consultation Podcast 15: How to Assess Risk in Your Portfolio 401(k) Survival Guide

Dean Barber: Thanks so much for joining us here on America’s Wealth Management Show. I’m your host Dean Barber, along with Bud Kasper. Okay. We are here, Bud, and we’re here to talk about something that I think is going to be critical to everybody out there that is still working, and this is even going to apply to people that are retired. We’re going to talk today about the importance of rebalancing.

Why Would I Want to Rebalance My 401(k)?

Dean Barber: Now, rebalancing your portfolio, whether it be inside your 401(k) or it is outside your 401(k), we have to first ask the question, why would we want to rebalance? What is the purpose of rebalancing? Is it to get better performance, or is it a risk mitigation tool? Bud?

Bud Kasper: It’s a risk mitigation tool by far, and it’s been a successful one for the most part for investors for a long, long time. But on the surface, it seems relatively straightforward, Dean. Still, in reality, there’s much more of an intricacy associated with rebalancing within the asset classes, let’s say stocks and bonds, to make it as a cursory format.

Rebalancing for Risk or Reward?

Dean Barber: Let’s first talk about this concept of rebalancing from a risk to a reward standpoint Bud, because I think that what happens is, and I think, more of a psychological thing than anything else. When you’re rebalancing, basically, you’re rebalancing because you have one of the asset classes do well enough that it’s got you out of balance.

Example Time

For example, if you were to say, hey, you’re going to start with 60% equities, 40% fixed income, and you want to hold that 60/40 type portfolio. If equities have a great year as they did in 2019, your 60/40 portfolio when you rolled into January 2020 was no longer a 60/40 portfolio. You now had far more equities than you had intended to have inside your portfolio. So psychologically, you look at that, and you say, I got to sell some of what made me money and what did the best last year. And I’m going to buy some of what held my portfolio back and total return last year.

That little devil on your shoulder named greed is sitting there saying, but Bud, why would I do that? I mean, I’m going to sell something that’s making me money, and then the other one made me a little bit of money, but it didn’t make me near as much as the one that you’re asking me to sell. Why would I do that? You do that to keep your risk in check; you must ensure that you keep your risk in check. If, for example, that 60/40 portfolio had turned into a 70/30 portfolio. So now, all of a sudden, you’re 70% equities and only 30% fixed income.

The COVID Crash

Now we can call it the COVID crash. Q1 comes around, COVID-19 rears its ugly head, and we get a steep drop in the stock market. It was one of the fastest declines in the stock market of all time. Had you not rebalanced back to the 60/40 allocation at the beginning of the year, you would have suffered a 26.5% loss with the 70/30 portfolio. Where if you had just done the rebalancing like you were supposed to, you only lost 21%. So you reduced your risk effectively in that first quarter of 2020 by about 20%.

Bud Kasper: I can see, or I wish I could see, but I could imagine that our listeners are going okay, Dean, that makes sense and everything, but let’s say human nature is what? Man, I just made money, let’s look at the market in 2019; you made over 28%. Wow, that is great. What are you going to do the next year? Let it ride.

Dean Barber: Yeah. Let it ride.

Rebalancing Frequency

Bud Kasper: No, rebalancing. But one thing that comes up, and there are so many little tidbits of, what I’m going to say is a technique that needs to be exercised because what’s the rebalancing frequency? Is rebalancing too many times in a given period a detriment to the outcome of the year, or should I be only doing it every quarter, every half year? All those things are necessary to understand.

But let’s go back to what we’ve experienced again. In 2019, where were we? We had a beautiful, had an incredible rally in the stock market. I don’t care what the portfolio is; as long as you had some participation in equities, you probably had a pretty decent year. We go into the new year, the COVID crash year, using your words, and what happens? February 19th market’s up 4.81%, man, it’s doing great. Let it ride.

Then what happens? In the next five weeks, we go from a 5% gain to almost 31% loss. So we have a 36% decline in five weeks, and now you’re going, why in the world didn’t I rebalance. Because you’re right, Dean, and the article written by Jason Newcomer, which people can get on our website, is an excellent read in understanding the power that rebalancing does. It is a discipline that makes you go back, take your profits, reorganize your risk position, and go forward from there.

401(k) Survival Guide

Dean Barber: Well, Bud, I’m glad you brought up that article because that’s really what we’re talking about today, rebalancing your 401(k). I want you to look at a couple of other things. In the 401(k) Survival Guide that we put together a couple of years ago, we’ve had tons of people download that piece, and you can too, just click here.

While you’re out there, understand this, we have the ability, with the advances in technology that have taken place over the last several years, to help you manage your 401(k). We can go in and do those rebalances; we can set the parameters, we can do it just as if we were you. The new technology allows us to do that. If you’d like to have a complimentary consultation to talk about how that works, you can schedule that right here.

We’re going to break down the pros and cons of rebalancing. We already said rebalancing is not necessarily a return enhancement tool, as much as it is a risk mitigation tool. So what is the cost to you in the long-term performance of reducing that risk? We’re going to talk about that, and we’re going to give you some specific numbers.

Why the 401(k)?

Dean Barber: Now, the reason why we picked on the 401(k) specifically, and to have you think about rebalancing that 401(k), is because in most cases, your 401(k) will be your largest asset. Now we know for most of you, it’s not your only asset. We’re going to talk about that later on in the program about how to look at total wealth asset allocation, as opposed to taking that 401(k) and just putting it under a microscope and looking at it as an individual part of your retirement future. But hey, the market’s been doing great. We’re off to another positive start for this year.

Why Should I Sell My Winners?

So, why in the world would I want to sell some of those winners? That part of my portfolio did the best. Why would I exchange it for fixed income? First of all, you have to decide what your asset allocation is. For the purpose of us talking about rebalancing today, we’re going to assume that, and this is just a hypothetical, if we were doing this for you, we would have a very scientific method of coming up with what should be your asset allocation.

We would then have a very scientific method of how often we should be rebalancing that 401(k). And it’s all based on the comprehensive financial planning that we do using our Guided Retirement System™. Still, for purposes of today’s radio program, we’re simply going to speak in terms of a 60% equity portfolio and a 40% fixed income portfolio.

Bud Kasper: Right.

What Does Rebalancing Cost You?

Dean Barber: Why would I want to, Bud, sell some of what did so well last year and put into fixed income? What is the long-term cost of doing that to mitigate the risk? We talked about how risk could be mitigated using the rebalancing methods, but what will it cost you? So I did a little bit of calculating before the show today, as you would expect.

Bud Kasper: Surprise, surprise.

Five Year Example, Rebalancing Frequency

Dean Barber: And here’s what I came up with: If you did a 60/40 portfolio five years ago and you didn’t rebalance, and again, we’re using indices here, S&P 500 and the Bond Aggregate. Okay?

Bud Kasper: Okay.

Dean Barber: 60/40, didn’t rebalance. You have a total return of 79.09% over the past five years. Pretty good. If you did annual rebalancing to mitigate that risk, your total return dropped to 74.71%. So let’s just call it 75%. If you did a quarterly rebalancing, your return is 76.21%.

So, you actually did better doing a quarterly rebalancing. Now, what about monthly? If you did monthly rebalancing, you’re 75.22%. So over the last five years, the best cadence for rebalancing would have been once per quarter; you would have sacrificed about 2.7% total return over five years. You’re losing about four-tenths of 1% per year in this example in total return to smooth that ride out, to keep risk at bay.

Is Rebalancing Worth it to Me?

The question you have to ask yourself, is it worth it? And if you’re 25 years old, you probably don’t have fixed income in your 401(k) anyway.

Bud Kasper: Yeah, probably not.

Dean Barber: Right?

Bud Kasper: Yeah. Go ahead and finish your thought.

Dean Barber: I was going to say if you’re 45 or you’re 50, or you’re 55 and retirement is getting closer and closer, by golly you better have some fixed income in there because Bud, you and I have lived through some of the worst market conditions that we’ve ever seen in the history of the stock market.

Obviously, we didn’t go through the 1929 market crash, but we had the 2000 Dot-Com bubble by golly when that thing burst, and then we had the financial crisis in ’07, ’08, and early ’09. And man, it can ravage your 401(k) if you don’t have some fixed income in there to protect you.

The Psychology of Ups and Downs

Bud Kasper: Yeah. The psychological problem with that is when you go through these extremes of the ups and the downs, and now you start second-guessing yourself, and now you say, “Well, I’ve got to get it back. So I’m going to get a little more risk in this portfolio because I have to get it back. It’s just driving me crazy that I had a drop.”

And yet, we know that’s the way markets work. I always go back to Mark Twain, who said, “History doesn’t necessarily repeat itself, but most of the time, it rhymes.” There’s a lot of truth to that statement, Dean. And so, if we look at what you were talking about on the different frequencies of rebalancing, I don’t care which one you choose. I don’t believe that you need to rebalance that often, but let’s say you did it every six months as an example; you’re still doing yourself some good from that perspective just because the odds are somewhat against you in getting repeats.

The Extremes Can Put You at Risk

Now, making that statement, I will tell you that one of the sources that I have for opinions of what’s going on in the market wrote an article recently that they talked about year to’s of…The length of time of returns. Year to’s are predicted this year from this particular source, and please don’t bank on this; they’re looking at 8.7% in the S&P. Well, look at that, if we had a 28% plus in 2019, we’d go into last year, and we have another incredibly strong year.

And now we’re looking at 8.7%. You say, “Why would I rebalance? You’re giving me information that says I ought to stay with the portfolio as it is.” Well, let me tell you, that ride, that rollercoaster could be extreme in between those points, and we have a lot of issues that I think will be coming up in the first quarter. I’m not just talking about the change of power in the White House and Congress as well. Certainly, that is a factor, but when you talk about the things that impact markets that make them go up and down, we’ve got some issues that we have to get past. And, of course, COVID is at the top of the list.

Dean Barber: It’s interesting that you bring that up, Bud. Don’t forget about our 401(k) Survival Guide, and you can get that here. 

Also, reach out to us for a complimentary consultation, which you can schedule right here. We can have a phone call with you. We can do a virtual meeting, or we can meet with you in person. Still, we can talk to you about the importance of rebalancing your 401(k) and looking at it in the aspect of your overall financial plan, and help you determine if you’re at the right risk level. 

Speaking of Risk

Speaking of being at the right risk level and how you assess risk in your portfolio, The Guided Retirement Show, which is a podcast that we do, in episode 15, I interviewed your son, Bud, Brad Kasper. We talk about how to assess risk in your portfolio. I invite you to find it on your favorite podcast app, YouTube, or click here. Episode 15, it’s how to assess risk in your investments. And this can go into your 401(k) and every other part of your plan.

Back to the 8.7% Return Prediction

Bud, let’s think about this prediction of an 8.7% return. You and I have looked for years at valuations of the market. And valuations today, the way that we look at them, have never been as high as they are right now, not even just before the Dot-Com bubble burst. But what’s different now? What’s different today than January 1st of 2000? 

Many things have changed, but we’ve got an accommodative fed, and we now have a Democratic-controlled House and Senate, and White House that I believe will throw so much stimulus at this economy. This could be a long-term peril to the country’s overall financial health, but the market loves that. So maybe that’s your 8.7% this year.

Approach with Caution

Bud Kasper: It could be, but I have caution associated with that, Dean, personally. I agree that the stimulus is out there. The effects of that could be incredibly positive for our investors. Still, in the interim period, I think we’re going to have to be more adroit in terms of making alterations to the portfolio to safeguard principle just as well.

Is Fixed Income the Safe Place?

Dean Barber: I agree with you. Now, the question becomes, is fixed income the right place to get that safety? Because remember, when interest rates rise, bond prices fall, like a teeter-totter. So if you’re going to be rebalancing, where do you go to rebalance? And what are the options within that 401(k)?

So it’s not as simple as we’re making it sound here. Just pick your 60/40 portfolio, your 70/30, your 50/50, or whatever it is and rebalance once. Look, there are more things at play here. Because if you think that bonds will deliver the same types of returns over the next ten years that they have over the last ten years, you got another thing coming. There’s just no way that that can happen. So where do you go?

Bud Kasper: Right. Well, you look at assets as a general, and you say, are they going to repeat? I don’t know.

Dean Barber: Well, we’re going to talk about where you go and how you determine that today.

Risk and Equity Valuations

We’ve already talked to you about how your 401(k) rebalancing should not be looked at as a performance enhancement tool. You should look at it as a risk mitigation tool.

For those concerned about risk, which should be the vast majority of our listeners, because the risk is real, this conversation is about you. 

Equity valuations today, as measured by four different ways that we measure risk; the Crestmont P/E, the cyclical P/E 10, the Q ratio, and the S&P composite from its regression- when we look at the average of those four, we have a price to earnings ratio that is 184% above the mean. The highest before this point was January 1st of 2000, when the average of those four was 164% above the mean.

What About the Great Recession?

Now get this, by the time the market finished its routing in the Great Recession, that same measurement of valuation was 8% below the mean. So we went from 164% above the mean to 8% below the mean. And now we’re back up to 184% above the mean. Look, stocks can stay overvalued for a long time, but something has to happen at some point in time. You have to have earnings grow fast enough to reach those valuations and bring them down, or the stock prices have to fall to bring the valuations back into a more normal level.

Bud Kasper: Yeah, but here’s the fault of that, and I’m aligned with your thinking here. Earnings should grow, but if earnings are growing, what do investors think? The price should continue to go up. Instead of earnings catching up to the price, now you’re going to see the price will go up. People will start bidding that up, say, “Boy, we were right, earnings are coming back. I should get a bigger reward than what I had at the beginning of the year.”

We’re talking about this specifically for 401(k)s because rebalancing 401(k)s is an easy, beautiful thing to do. It has one advantage over our regular portfolios outside of the 401(k); there are no tax consequences to the rebalancing.

For those of you who already retired or about to retire and aren’t using 401(k)s anymore, the same thing works out. We just have to put a tax overlay on top of that to ensure we’re getting as much efficiency from a tax position as we are from the risk adjustment from the rebalancing.

Another 401(k) Rebalancing Example

Dean Barber: Right. Well, I’ll give you a perfect example, just at the end of last year, or the first part of this year, we did some rebalancing for a client, and they have some significant money outside well as inside of their retirement accounts. So we did all of the rebalancing inside the 401(k) because we didn’t want to trigger capital gains outside the 401(k). 

When we started talking about this rebalancing idea earlier in the show, I commented that you can’t look at your 401(k) as a standalone asset unless that’s the only money you have. Typically, you’re going to want to look at your 401(k) as a part of your overall asset allocation. You may wind up with an inordinate amount of fixed income or more conservative investments inside your 401(k) because you’ve taken some risk off the table. This might happen when you have equities outperforming, and you don’t want a capital gain in a given year to rebalance your taxable accounts.

Don’t Go Blindly into Rebalancing Your 401(k)

Don’t go into this blindly, and don’t just think,” I got this. I’m going to punch a button and do a reallocation inside my 401(k). Look at it in the aspect of your overall financial plan. We use a proprietary system called your Guided Retirement System™ that gives us the ability to say, “Okay, here’s how much you should have in each asset class. Here’s which tax bucket it should be in, whether it’s in your taxable account, your tax-deferred account, or your tax-free account.” It’s all part of what we do for our clients every single day. 

I’d love to have you experience this. You can find out by scheduling a complimentary consultation right here. You can do a phone call, a virtual meeting, or we can meet in person.

What About Bonds?

Bud, we talked in the last segment about this idea of fixed income. So we’ve already alluded to the fact that we’ve got equities overvalued, but we also said that equities could remain overvalued for extended periods. We’ve seen that in the past. What about fixed income right now? What about bonds? And we said if interest rates rise because the economy takes off and the COVID vaccines are effective. Everybody gets back out to spending and doing their regular stuff; interest rates will probably go up. Well, what’s that do to bonds? 

Bud Kasper: They’ll go down in value. And therein lies an additional subject to what we’re talking about with rebalancing, which is diversification within asset classes. Now I’m not trying to confuse anybody, but there are different types of bonds. So how you diversify your portfolio’s bond portion, coupled with the rebalancing, is one issue. 

We have the same thing with stocks, the diversification between large-cap, mid-cap, small-cap versus value versus growth, et cetera, et cetera.

Which also forms what we call rebalancing, but it’s when inside the category of investing. So if it sounds complicated, the answer is; it is. It takes a lot of skill and experience to be understanding where we are, what is attractive, what’s not attractive, and how we’re going to try to exercise these returns consistently through the use of asset allocation.

Stocks and Bonds Example

Dean Barber: Let me give you an example here, Bud, so our listeners can understand what you’re talking about. So just like every stock is not the same, every bond is not the same. There are different classes of bonds. So if you looked at the same 60/40 model that we’ve been talking about, and you look at the last quarter, so going over the previous three months, the 60/40 portfolio would have returned 4.87%.

Well, what happened to the S&P 500? The S&P 500 was up 8%, and yet your total return for the 60/40 was 4.87. Why? Because if you just use the bond aggregate, that was a negative 0.37% over the last three months.

Bud Kasper: Yeah, the aggregate is the average.

Dean Barber: Yeah, the average. So now, but if you have a portfolio that’s weighted heavily in the floating rate bonds, that particular asset class up 3.48% in the last quarter, so if you had a 60/40 mix with floating rates, as opposed to just looking at the bond aggregate. Again, some of these things may not be available in your 401(k). That’s why it’s so important to assess your portfolio overall. You should look at the assets outside and inside your 401(k) and develop an asset allocation strategy on everything.

There are Specifics in Every Strategy

Bud Kasper: Absolutely. It’s a whole package deal. I’m just saying that there are some specifics associated with every strategy. The investments that you have inside your 401(k) will determine how effective all this is.

Dean Barber: Right. Before you rebalance, what I would suggest is you request that complimentary consultation, understand that we can help you with the management of that 401(k) and the design of how to allocate it and put you on the right track. It’s all done using our Guided Retirement System™.

What’s Next?

Dean Barber: All right, so we’re talking today about rebalancing your 401(k). We’ve talked about the inherent risk in the market and where we are as far as valuations today. We talked about the inherent risk that is there today in some parts of the fixed income market, Bud, that being bonds, and some bonds will fall faster than others as interest rates rise, and some bonds will do well during a rising interest rate environment.

What Should My Asset Allocation Be?

So, the question that’s on the table is that each of you should be asking yourself as you’re listening to us is, “What should my asset allocation be? How should I position my portfolio at this point in my life?” And unfortunately, that question is not an easy question to answer. Yes, you can read a book that’ll tell you to own your age in bonds and some BS like that, but come on, that would be treating us all like cattle and that we should all do exactly the same thing.

Goldilocks Portfolio

So the reality is that each one of you has what I will call a “Goldilocks portfolio,” one that’s just right for you. And we can identify your Goldilocks portfolio, the one that’s just right for you, by utilizing our Guided Retirement System™. 

Well, how does that work? We simply look into the future, and we say, what do you want your life to look like? What are the things that are important to you? What do you want to do? How much income do you need to do all the things that you want to do? And we understand that money in and of itself isn’t the goal. Money is how we’re going to pay for the goals. It’s how we’re going to pay for our lifestyle, et cetera.

Determining Your PRI

Okay, so if we understand that, and then we know all of the resources you have and your potential to save from this point forward, we can then identify your PRI, your personal return index. What does your money need to do for you to get to where you want to be? Then that’s when we go into the portfolio design and the asset allocation that gives us the best opportunity to achieve your personal return index with the least amount of risk possible from a historical perspective. 

We do this using our Guided Retirement System™. Schedule a complimentary consultation with us. We’ll walk you through it and let you see what your money needs to do for you to be able to accomplish everything you want to accomplish. Sometimes we have to give bad news and say, you know what, what you want is not reality, let’s talk about some sacrifices here. Or you might say, you know what, you’re already there, you’ve done it, now sign to protect. I don’t know what the answer is, but I know that once we talk to you with that complimentary consultation, we can arrive at your Goldilocks portfolio.

The Personal Retirement Index

Bud Kasper: Right. You know, it’s funny, Dean, you jogged my memory there with the PRI. You and I and one of the other partners of the firm, Eric Sheerin, came up with that. I think it was ten years ago.

Dean Barber: Yeah, at least ten years ago, yeah.

Bud Kasper: We were sitting there looking at all these returns, returns, numbers, numbers, numbers, and we’re saying, you know what, none of this makes any sense unless it applies to each of our clients individually. So let’s do it, let’s drive all of our information so we can create a personal retirement index, or return index, that is suitable to that specific person. And that’s what we’ve carried forward in our Guided Retirement System™, so it’s a beautiful thing.

The Guided Retirement System™

Dean Barber: It is. And there is so much comfort in knowing what your money needs to do. It’s almost like you’ve got a GPS, which is why we call it Guided Retirement System™, right? You’ve got a GPS that’s telling you, okay, we’ve had a little detour, we stopped for this break. All right, what’s my new time of arrival?

With your Guided Retirement System™, it’s the same thing. It’s saying, what am I trying to do, what am I trying to accomplish, what are my long and short-range goals, and what are my resources? As things change in your personal life, the economy, and the markets, where you are on your path changes as well. So, it’s freeing to see, “Here’s where I am, and here are the results of what I’ve done.”

Bud Kasper: Right, exactly. So, you know, what we want everybody to have, and we mean this with all sincerity, we want you to live your one best financial life. 

Back to Bonds

You know, Dean, I want to drop back to bonds for just a moment, if you don’t mind. And that is, you know, bonds are not absent of risk. And I think we’re going to see some of that this year. If we looked at what happened during the COVID crisis, we saw a period where we had a contraction in bonds that, quite frankly, was shocking. 

That’s even the highest quality bonds dropped from about 6.2% on March 3rd down to 0.3% by the time we got about seven or eight days later. Some of the more volatile types of bonds, and yes, individual bonds are volatile. They had even more extremes. I can think of one that had almost a 13 and a half percent drop during that timeframe. And now you go, what’s going on? These are supposed to be at the safe part of my portfolio.

Thank the Fed

Well, nothing is exactly safe. Thank goodness for Jerome Powell, Dean, because on that bottom of that nine-day segment that I was talking about, the Federal Reserve came in and did something they hadn’t done in years. That’s maybe ever, and that is they came in and said, 

“We will be the buyer of last resort on any bonds.” 

So typically, we think of the Federal Reserve and treasuries. Now we’re talking about high yield bonds, mortgage-backed bonds, even municipal bonds where the Federal Reserve came in and started buying these to do what? To stabilize the market. A smart thing for that man to do, which helped out the bond market completely, and we got a recovery that came out of that. So, God bless him and the other members of the FOMC.

Bonds are a Stay Rich Asset

Dean Barber: Well, they provided liquidity is what they did, and that’s what the markets needed. But if we understand this, we’ll leave you with this thought on bonds as we wrap up your radio program here today. I believe that bonds are the stay rich asset where stocks are the get rich asset.

So if you understand that all bonds mature at $100 par value, if you know what you’re going to pay for that bond and you know what the yield is on the bond, and you know when the maturity is on the bond or the callable date of the bond, then you can calculate your total return if you hold that bond to maturity. Bud, the trap that people fall into is they look at the bond and don’t understand that at some point in time, that bond is going to mature at par value, and if it’s trading below par value, you don’t sell it because why? Because it’s going to trade back at par when it matures.

Bud Kasper: Exactly.

Get Clarity

Dean Barber: So that’s why I say bonds are stay rich asset. You have a known outcome, especially if you’re buying individual bonds. Now, individual bonds work well in some cases, and in some cases, a bond ETF or a bond mutual fund may be a better option. We can help you figure all that out using our Guided Retirement System™. 

So schedule your complimentary consultation right here. Remember, we can meet via a phone call, virtual meeting, or in-person. Either way, let’s help you figure out where you need to be in this crazy world that we live in today.

Thanks for being with us here on America’s Wealth Management Show, I’m your host, Dean Barber, along with Bud Kasper, and we’ll be back with you next week, same time, same place. Everybody stay healthy and stay safe.