Personal Finance for Professionals Part II – Investing in Stocks & Bonds
Welcome back to Personal Finance for Professionals Part II, our multi-lesson series teaching you everything you ever wanted to know about investing in stocks and bonds. In Lesson 9, we covered the relationship between stocks and bonds and explored asset allocation. In the final lesson of Part II, we will discuss portfolio maintenance and asset location, and we will try to put everything you’ve learned in the first two parts of this series together in a simple framework.
** Quick Note- We apologize for starting Personal Finance for Professionals Part III – Real Estate Investing before we finished Part II. Heather and I are working on these different parts separately, and our release schedule overlapped by a week. This is the last lesson in Part II, so you can now enjoy Heather’s series on real estate while I return to more stand-alone posts for a while. Sorry for any confusion! **
Portfolio Maintenance
In the last lesson, we discussed asset allocation between stocks and bonds. While I want my retirement portfolio like my romantic relationship: low maintenance and without drama, there’s no such thing as no maintenance. Whether you’re at the beginning of your career with a 90:10 stock/bond split, or are closer to retirement at 60:40, these percentages won’t remain static. Aging, returns, shifting goals, and new investments will change your asset allocation, so you’ll need to modify and update your portfolio periodically.
Rebalancing a Portfolio
A diversified portfolio of stocks and bonds will naturally change over time. If stocks are doing well, bonds usually aren’t, which will shift your portfolio to become “overweight” (a higher percentage than your desired allocation) in stocks. Conversely, when the stock market is down, the bond market is usually flat or slightly up, causing your portfolio to become “underweight” in stocks.
You may initially purchase index funds in such a way that your asset allocation is 70% stocks and 30% bonds. However, if the stock market performs well while the bond market falters, your portfolio may drift to 80% stocks and 20% bonds after a few years without your intervention. Rebalancing occurs when you purposefully return your portfolio to a predetermined asset allocation.
The negative correlation between stocks and bonds works to your advantage when rebalancing your portfolio. If one asset class goes down when the other goes up, rebalancing forces you to shift back toward the (relatively) undervalued one.
Methods of Rebalancing
There are two ways to rebalance a portfolio. The first is the buy/sell method: you either sell stocks to buy bonds or sell bonds to buy stocks. You sell the one that is overweight in your portfolio and buy the one that is underweight, allowing you to always “sell high” and “buy low.”
Example 1: Buy/Sell
You have a $1,000,000 portfolio split 50/50 between stocks and bonds inside your retirement account at Year 1. If at the end of the year, stocks have risen by 20%, and bonds have fallen by 10%, you now have $600,000 in stocks and $450,000 in bonds. Your total portfolio value at the start of Year 2 is now $1,050,000, but your asset allocation is 57/43.
To rebalance your portfolio, you would sell $75,000 of your stock fund and purchase $75,000 of your bond fund. The net result is that you now have $525,000 in stocks and $525,000 in bonds.
The second method you can use to rebalance is to skew new purchases to affect your overall asset allocation. Dollar-cost-averaging is a form of rebalancing. If you always buy 70% stocks and 30% bonds at each purchase interval inside your retirement account, you naturally buy a smaller number of shares when the price rises, and a higher number when it drops. However, this may not be enough to offset large movements in asset prices. To fully rebalance, you may have to buy 100% stocks one year when the S&P is down, or 50% bonds one year if the stock market is up.
Example 2: Skewing New Money
You invest $70,000 into your SEP IRA each year at your desired 70/30 allocation. Your portfolio value is currently $400,000; however, recent market returns have left your asset allocation at 65/35. Your portfolio holds $260,000 in stock funds and $140,000 in bond funds. You are overweight in bonds.
When it comes time to allocate your next $70,000, you choose to buy $69,000 of the stock fund and $1,000 of the bond fund, leaving you with $329,000 in stocks and $141,000 in bonds. You now have a total portfolio value of $470,000 and a 70/30 split.
The Buy/Sell method works best when you are no longer adding to your portfolio at regular intervals, or when your new contributions are low relative to your account balance. It also works best inside retirement accounts where you don’t have to pay taxes when you sell appreciated assets.
The Skewing New Money method works best in taxable accounts and when your account balances are small enough that a yearly investment can still move the needle. You can, and likely will, need to combine these two methods throughout your investing career for effective rebalancing.
When Should You Rebalance?
Two schools of thought exist on when to rebalance. First, you should rebalance at set intervals, neither too close together (monthly, quarterly), nor too far apart (every five years). The optimal schedule would be between every year and every two years.
Another option is to set “guardrails” and rebalance only when your asset allocation drifts by more than a specific amount, such as 5% or 10%. For example, if your goal is a 70/30 portfolio, only rebalance when it gets to 75/25 or 65/35.
You can combine these ideas by scheduling a rebalance every year and also rebalancing if your portfolio hits these guardrails. I think this is probably overkill for most medical professionals, and the best advice I have heard is to rebalance every year on your birthday, since too many people rebalancing on January 1st might slightly influence the market. If this is too much work, do it every other year.
The most important concept to grasp is that your portfolio’s asset allocation is not static and will require periodic rebalancing. How often you mechanically rebalance matters less, as long as you pick a schedule and stick with it.
Does Rebalancing Improve Performance?
The short answer is no; rebalancing will not improve your portfolio’s performance. Bull markets tend to run longer than expected, and by selling high, you may actually reduce performance in the short term. That doesn’t mean that rebalancing is bad, though. Like the Starks’ motto in Game of Thrones, “Winter is coming,” when it comes to the stock-market, “a downturn is coming.” When a downturn in the stock market occurs, your efforts will pay off, and rebalancing should be a net zero over the course of your 30-40 year investing career.
So, if rebalancing doesn’t improve performance, why should you do it? Because it reduces volatility (risk). Think about two investors hiking to the top of a mountain. Investor A takes a winding, well-demarcated path to the top. It is the long, boring way, but it will get him there safely. Investor B hikes up the side of the mountain. At times, when the path is easy, she gets ahead of Investor A. But when she hits a difficult stretch, she has to slow down and rock-climb, allowing Investor A to catch up. Almost inevitably, they reach the same place at roughly the same time. Maybe one gets there a little faster, maybe not, but there is no question that Investor B had a higher risk of falling off the mountain.
Target Date Retirement Funds – The Simplest Option
Some of you reading this will be torn. You don’t want to hire a financial advisor who charges AUM fees to manage your portfolio, but you don’t really want to do it yourself either. And that’s fine. While every medical professional should learn the basics of personal finance, many of us are more interested in other things, like being a good doctor!
I try to keep investing as simple as possible. While I don’t give direct investing advice, I believe that most people should stick with only three index funds: a total US stock market fund, a total US bond market index fund, and an ex-US international index fund. But if even the thought of managing and rebalancing three funds every other year makes you nervous, may I suggest an even easier option: the target date retirement fund.
Target date funds automatically rebalance and adjust their stock/bond allocation based on a specific retirement date. Target funds can be actively or passively managed and can contain mutual or index funds. By now you can guess that I recommend, if you go this route, to choose a passively managed index target retirement fund.
A target date fund automatically does two things for you: it adjusts your asset allocation as you age and periodically rebalances the portfolio. You simply choose the year you plan to retire.
For example, the following might be the schedule for a Target Date 2050 Fund:
- 2027-2032 (85% Stocks: 15% Bonds)
- 2033-2038 (80% Stocks: 20% Bonds)
- 2039-2044 (75% Stocks: 25% Bonds)
- 2045-2050 (65% Stocks: 35% Bonds)
- 2050 & Beyond (60% Stocks: 40% Bonds)
Since it is a passively managed vehicle, it automatically rebalances and adjusts the asset allocation to be less aggressive as you near retirement age. In the above example, by 2050, the fund is at your desired retirement allocation, 60:40.
These funds are as close to a “set-it-and-forget-it” investment that exists. Your only decision is what target year to choose. If you are conservative, choose a target date that aligns with your anticipated retirement, as the underlying asset allocation is designed to be conservative. If you want to be more aggressive (meaning a higher stock allocation), just choose a later target date. If you think you will retire in 2050 but want to invest more aggressively, choose a 2060 target date instead. Your asset allocation will favor stocks more heavily through 2050, and you can still access your money at your retirement age.
Once you have chosen your target year, you just have to fund it. I recommend automating your investing. Dollar-cost-average into the fund during your working years, and you will be prepared when you retire.
Finally, remember that target date funds are simply an investment vehicle, not an investment account. You can hold a target date fund in your retirement account (401(K), 403(B), SEP IRA, etc.) or in your brokerage account.
Putting It All Together
Part I of this series taught you why you should learn about personal finance, introduced an order of operations to follow, and provided a rough guide on how much you will need to retire. In the last ten lessons of Part II, we discussed stocks, bonds, and how they interact within your portfolio, with the ultimate goal of learning how to invest for your retirement. Let’s conclude with a recap of the mindset, mechanics, and market dynamics that help us put it all together.
Mindset
Investing is a long-term endeavor; think in decades, not months or years. You won’t get rich overnight, but you will get rich over the course of your career.
Check your ego at the door. Regardless of the letters behind your name, you are not smarter than Wall Street. Spend your time being a good doctor instead of trying to beat the market.
Mechanics
Follow the Financial Vitals Checklist. It will always guide you to the next step on your investing journey.
Fees matter. Avoid them as much as possible. If you need help, use an advisor you pay by the hour to avoid AUM fees.
Automate as much of your investing as you can. Automate contributions to your retirement and brokerage accounts every pay period.
Market Dynamics
Buy diversified stock and bond index funds with low fees in a predetermined asset allocation. Buy regularly and often. Market returns will make you wealthy in time.
Keep investing no matter what the market is doing. fact, it’s even better if you don’t pay attention. Let DCA, compound interest, and time do their thing.
That’s it for Personal Finance for Professionals Part II – Investing in Stocks & Bonds. Thanks for reading. If you have any questions or comments, please leave them below. Our comprehensive overview of personal finance continues with Part III – Real Estate Investing, which Heather has already started!