Blind Adherence to Re-balancing May Be Hazardous to One's Wealth - TheStreet

Annually at this time of year, we are inundated with financial advice columns suggesting that investors re-balance their investment portfolios.

Conventional wisdom states that it is prudent to sell a portion of an asset class that has recently outperformed to buy the asset class that has recently under-performed in order to bring the long-term target asset allocation back into balance. This year, that translates into advice that investors sell stocks to buy bonds.

This makes sense in most market environments. However, not all markets are created equally.

The problem is that the value of one asset class -- bonds -- is largely determined by mathematics. Specifically, as market interest rates rise, the value of existing bonds fall.

Additionally, when market interest rates are really low, even a small increase in those rates can lead to large drops in the value of longer-duration bonds. We have seen some recent carnage in the bond market following Donald Trump's surprising presidential election victory.

Consider that the holder of a 10-year Treasury note would have seen the value of that note fall by the equivalent of three years' interest payments in just 10 days following the election. In a low interest rate environment, rising rates are hazardous to bondholders' wealth.

Following its meeting this month, the Federal Reserve Open Market Committee increased the target fed funds rate by 25 basis points. In addition, Federal Reserve officials indicated that they expect to raise rates next year by another 75 basis points, likely in three 25-basis-point moves.

There is a logical inconsistency for investors to re-balance from equities to bonds now. When rates rise, the value of bonds fall.

And when rates rise from a really low level, bond values fall precipitously. Rates are historically low, and the body that has the single most influence over interest rates has indicated that it plans to raise them over the next year.

Re-balancing at the end of this year would mean selling stocks that have recently outperformed to buy bonds that we expect to suffer from increasing rates next year. That is a tough sell.

That is asking someone to sell an asset that has been outperforming to buy one that is definitely going to face headwinds next year.

The discomfort that many investors feel with relatively high stock market valuations is understandable. Since the election, the market has risen, and market fundamentals really haven't significantly changed.

Although there is certainly reason to be optimistic with respect to potentially lower tax rates and increased infrastructure spending, it seems that animal spirits are driving the market. That is, people are optimistic because they are optimistic.

But it is also true that across all economic environments, the values of stocks tend to rise over time and benefit those with very long investment horizons.

Over the long term, re-balancing is definitely a wise move to make, but blind adherence to any rule is problematic.

American civil rights activist, memoirist and poet Maya Angelou once said "When someone shows you who they are believe them the first time."

The advice to bondholders is similar.

When the Fed tells us what it plans to do, believe it. And when it comes to potential re-balancing for a portfolio, believe them today.

This article is commentary by an independent contributor.

Robert R. Johnson is chief executive and president of the American College of Financial Services.