The beginning of a new year is a time for review, reflection and resolutions. When it comes to your money it’s the perfect time to set goals, make changes and resolve to stick to those changes long term. Whether it’s setting up and funding an IRA or just putting extra money aside for a rainy day, whatever the goal, how your money is invested, its asset allocation, and consistent rebalancing will be some of the most important decisions you’ll make as an investor.
What Is Asset Allocation?
Asset allocation is an investment strategy based on finding a balance for your money between different assets that fits your goals and risk level. These assets are broken down into three main classes – equities (stocks), fixed income (bonds) and cash – which will make up your investment portfolio.
Unfortunately, there is no simple formula for figuring out your perfect asset allocation. But there are some rules of thumb to follow. The most important decision will be the split between risky and non-risky assets or your stock/bond split. A conservative rule is to have “your age in bonds”. According to this rule, if you are 40 years old, 40% of your portfolio would be in bonds. For those who prefer more risk (age – 10) adjustments can be made. It offers a starting point. Once you have an asset allocation that you’re comfortable with, it’s time to make sure you stick to it.
The Importance of Rebalancing
Over time, certain asset classes tend to outperform others. This can pose a problem when it comes to your asset allocation. Sure your portfolio may be performing well, but in return you’re also taking on more risk. Which is where rebalancing comes in.
Rebalancing is an investment tactic that is used to maintain an asset allocation. It sells the better performing assets and buys the under-performing assets. This may not sound “right,” but it enforces a “buy low”, “sell high” philosophy, all while maintaining your asset allocation and risk level. The hard part is knowing when it is the best time to rebalance, and following through on it.
There are several different approaches to rebalancing. One of the simpler one’s is based on a 5% fluctuation in your portfolio. Say you have a 60/40 split, 60% in stocks and 40% in bonds. You would rebalance your portfolio when your split reaches 65% stocks/35% bonds or 55% stocks/45% bonds.
Another approach is to rebalance at specific points in time i.e. monthly, quarterly or annually. One thing to keep in mind is transaction costs. Commission fees can cut into your profits, so choose a rebalancing approach that works for your investments and your wallet. Or work with an investment company that rebalances your portfolio for free.
Betterment does this for you. Based on your long term goals and time lines, Betterment recommends an asset allocation based on your level of risk and goals. It also automatically rebalances your portfolio every quarter and any time your allocation strays more than 5% away from your target.
The Rebalance Bonus
Several studies have shown the long term effects rebalancing has on a portfolio. Forbes recently compared $10,000 invested in two 60% stocks/40% bonds portfolios over a 25 year period, one with annual rebalancing and the other never being rebalanced. The rebalanced portfolio became $97,000 while the never rebalanced portfolio only grew to $87,000.
There are a few things to note about the study. When the stock market was outperforming similar to the 90s market boom, the unbalanced portfolio performed better, but did so at a much higher risk. On the other hand when the stock market was declining, the rebalanced portfolio had much lower losses in value.
While the study argues for a better return due to rebalancing, it is more important to point out the defensive nature of rebalancing when the markets go down. Consistent rebalancing does a much better job of protecting your investments from taking on excessive risks. In doing so, you will still achieve very good annual returns.
One of the most important takeaways you can bring with you this year is to pick the right asset allocations for each of your long term financial goals and stick to them through rebalancing. In this way, your future savings and nest egg will be far more secure.