IndexUniverse: Do you think that the stock market is overbought right now?

Swedroe: Generally, I think the stock market is the best estimate of the right price. But we do know that high PEs predict low future returns. For example, when PEs were over 22, for the next 10 years stock returns were around 5%. On the other hand, when PEs were less than 10, stocks returned about 17%. When the PE was roughly between its average of 14-16, then stocks returned about 10%—their long-term average.

IndexUniverse: Where are PEs now?

Swedroe: Let’s look at the Vanguard Total Stock Market Index Fund (VTSMX). Its trailing PE is at around 12 right now. Then, let’s look at the Vanguard Total International Stock Index Fund (VGTSX), which is at 10.6. And Vanguard’s Emerging Markets Index (VEIEX), which is up almost 40% this year, is virtually the same. So stock PEs are below their long-term averages. That means stocks’ expected returns should be above their long-term averages. The equity risk premium is now greater than their long-term averages.

IndexUniverse: Is buy-and-hold investing dead?

Swedroe: Of course not. Buy-and-hold doesn’t mean you shouldn’t do anything at all, though. You need to buy, hold and rebalance. You’ve got to adhere to an investment plan. And that, by definition, means rebalancing it to adjust to the way markets flow. All along the way, you need to rebalance your portfolio. But time-based rebalancing doesn’t make any sense. You should do risk-based rebalancing. You set a band around each asset class.

IndexUniverse: What are your general thoughts about how people should rebalance their portfolios?

Swedroe: Each person has their own requirements. But any time you have new cash, you should rebalance. And people should remember that since time and costs are real considerations, you want to let your portfolio drift a little. But generally, I like to take a 5/25 approach. That means if an asset class has moved an absolute 5% or a relative 25%, you should probably rebalance.

IndexUniverse: How does that work?

Swedroe: You want to do a rebalancing test at three broad levels. The first is stocks vs. bonds. The second is domestic vs. international stock and then, thirdly, you’ve got to check by size and style as well as separate asset classes on the stock side. That applies to bonds, as well.

IndexUniverse: Can you provide an example of how that would work?

Swedroe: On the individual level, say you only want 4% in commodities. So I’d take 25% of 4%, which is 1%, and I’d rebalance once it goes beyond a 1% move—meaning below 3% or above 5%. But if you’ve got short-term capital gains taxes involved, then I’d wait to rebalance until you’d be triggering long-term capital gains. Or, you can use new money when it’s available to buy more of the under-performers.

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