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Lessons from the "Lost" Decade: Rebalancing, Bonds and Correlations

As we continue our look at investing lessons learned from the past decade, I'm reminded of three important ones that are "required courses" -- the importance of rebalancing, the role of fixed income and the effect on risky asset correlations during times of crisis.

The Importance of Disciplined Rebalancing
Buy-and-hold is not the winning strategy. The winner's game is played by buying, holding and rebalancing (and tax-loss harvesting for taxable accounts). Consider the following example.

Mike enters 2000 with a $100,000 portfolio that is 60 percent S&P 500 Index and 40 percent one-year Treasuries. Unfortunately, he gets hit immediately with a bear market. That leads him to commit the "misdemeanor" of failing to rebalance during the decade. (At least he didn't commit the "felony" of panicked selling). He closed 2009 with his portfolio worth $112,700.

Joe begins the decade with the same portfolio. The only difference is he maintains discipline and rebalances on a quarterly basis. He ends 2009 with a portfolio worth $114,500. Despite equities producing negative returns during the period, rebalancing led to Joe outperforming Mike by $1,800. Thanks to disciplined investing, he's now closer to achieving his financial goals.

The lesson is that when the going gets tough, the tough rebalance.

Don't Take Risk in Fixed Income
The main roles of fixed income in a portfolio should be:

  • To provide liquidity for both known and unexpected needs
  • To dampen overall portfolio risk to an acceptable level
Stretching for yield (often confusing yield with return) may cause you to invest in such fixed-income investments as high-yield bonds, convertible bonds, emerging market bonds and preferred stocks. Unfortunately, these investments have equity-like characteristics. Thus, they tend to do poorly just when stability is needed most.

2008 provided the perfect example of why you should avoid taking risk in the fixed income portion of your portfolio. Stick to direct obligations of the U.S. Treasury and U.S. government agencies, and municipal bonds that carry at least a AAA or AA rating. (And the insurance wrapper doesn't count. The bonds' underlying rating should be that high.) That was another painful lesson investors had to learn in 2008.

Risky Asset Correlations Rise During Crises
In 2008, all equity asset classes fell sharply, as did all risky fixed income assets, such as the risky fixed-income assets mentioned above. This was nothing new, as the same thing had occurred both in the summer of 1998, during what came to be known as the Asian Contagion, and in the aftermath of the events of September 11, 2001. (Remember, the only thing new in investing is the investment history you don't know.)

Diversification of equity risk works in the long term, but not necessarily in the short term. And it requires discipline. The lesson is that the most important diversification is ensuring there's sufficient high-quality fixed income to dampen overall portfolio risk to the appropriate level.

Follow the series: Lessons from the "Lost" Decade