Category: Investment

No institution arguably has more influence over our economic lives than the Federal Reserve (the Fed), which serves as the central bank of the United States. Contrary to what its name might suggest, the “Federal” Reserve is not a government entity but an independent central bank that is owned by its member banks, including familiar names of JP Morgan Chase, PNC, and Bank of America. It wields power, to the extent that investors scrutinize the importance of every word uttered by the Fed’s Chairman, which can dictate market movements.

Despite the potential negative connotations associated with the Fed’s significant power, their primary mission is to ensure economic stability, for the benefit of businesses and individuals. They do so by using the monetary policy, which controls the level of the money supply within the economy. In the last few years, the federal funds rate, the short-term interest rate set by the Fed, and one of the monetary policy tools, has been a focal point among investors. As we expect interest rate cuts to begin this year, based on comments from the Fed’s chairman, Jerome Powell, who has indicated that the current interest rate of 5.5% is likely the peak for this economic cycle, we will examine three implications of such cuts, from investors’ perspective.

From 1990 to 2007, the size of the finance industry grew at a rate that was 64% faster than that of the entire economy. This rapid expansion of the financial sector, which occurred without proper oversight, played a significant role in triggering one of the most severe economic downturns in history in 2008. The aftermath of this recession left a lasting impact, fostering distrust and resentment among the public towards the finance industry. The documentary made by PBS titled The Retirement Gamble, created a few years after the crisis, depicted the discontented hard-working people who had been sold unsuitable financial products, leaving them in the dark about their investments.

Despite the widespread availability of the internet in the early 2010s, there existed a profound informational asymmetry between finance professionals and the general public. It was a common practice then that investment products used in retirement accounts, such as 401k, as well as in individual brokerage accounts, unbeknownst to investors, had excessively high management fees. Combined with additional fees paid to administrators of these accounts, including financial advisors, the total management cost could exceed 2% of the portfolio value. The journalist in the documentary is shocked to discover how the cost of 2% a year, seemingly a small number, can significantly diminish one’s investment returns in the long run, due to its compounding effect.

Investors buy and sell financial instruments, often influenced by media reports and public sentiment. However, through decades of research, scholars have largely concluded that any information publicly available is already reflected in asset prices, resulting in an expected return to zero at any given point in time. The economist John Maynard Keynes even described perceived information as merely noise. In contrast, professional financial managers distinguish themselves from these “noise traders” by employing periodic portfolio rebalancing to systematize and bring discipline to their investment processes. The question remains: does this approach introduce predictability to investments?

To perform portfolio rebalancing, one needs predefined asset allocation targets, such as 60% stocks and 40% bonds, and the process involves adjusting the portfolio back to these target allocations when it drifts away from them. For example, when the stocks in the portfolio appreciates to 70% at the end of the year, one would sell a portion of it and invest in bonds and bring back the portfolio to the original target. Wealth managers widely recommend this practice suggesting that it allows investors to buy assets when they are undervalued and sell them when they are overvalued, potentially benefiting all investors. The aim of this article is to assess the validity of this presumption, and make a casual examination of portfolio rebalancing and evaluate whether it is suitable for every investor.