Last week, I continued with part two of a three-part series on the biggest component of investing success: asset allocation. Today, I close with a primer on rebalancing, the most overlooked (yet arguably most critical) part of asset allocation in the real world.
What I described at the end of last week’s post (the gradual re-organizing of your asset allocation as you age) is called “rebalancing.” Unfortunately, despite its colossal importance, rebalancing does not happen by itself.
For instance, recall that this might be your target asset allocation in the beginning:
Ideally (if you determine that it is the correct one) you should keep this allocation for at least the next several years. Yet, because the market is constantly fluctuating, your asset allocation could wind up looking like this only 12 months later:
The problem is not anything you personally did. You set up your asset allocation to reflect your goals, time horizon, and risk tolerance exactly like you were supposed to. It simply happened naturally, as a result of the companies you invested in going up or down in value.
That’s why you need to rebalance, or bring your portfolio back into compliance with your chosen asset allocation. It’s not a particularly exciting task, and your portfolio will not cry out to you to be rebalanced. As such, it’s very easy to forget about, which is precisely what most investors do.
This is perhaps the most dangerous mistake untrained investors make. A portfolio that never gets rebalanced is like an ocean barge that veers off course. If the captain doesn’t straighten the ship out, it could wind up in Cuba instead of the Bahamas. Likewise, your portfolio could be exposed to exponentially more risk than you are comfortable taking on—all because you neglected to rebalance.
Rebalancing can be done manually, or semi-automatically through what are known as lifecycle funds. A lifecycle fund re-calibrates your holdings over time to stay aligned with your desired asset allocation. Just know that whether you use a lifecycle fund or go it alone, rebalancing is absolutely essential to keeping your portfolio invested in the right things, and that failing to do it places you in huge danger the longer it goes unaddressed.
Risk vs. Return in Real Life
In closing this series, I want to stress that although there are formulas and systems to get asset allocation right (and I highly recommend sticking to them when possible) there is an emotional component to all of this as well. And it can be exceedingly difficult to keep your emotions in check when faced with data that provokes strong reactions, fears, or impulses.
That said, successful investing is all about learning to do just that. For every data point that causes you to worry, there are others that (even if they don’t completely remove your worries) should cause you to consider another perspective.
As Wikipedia explains:
“In asset allocation planning, the decision on the amount of stocks versus bonds in one’s portfolio is a very important decision. Simply buying stocks without regard of a possible bear market can result in panic selling later. One’s true risk tolerance can be hard to gauge until having experienced a real bear market with money invested in the market. Finding the proper balance is key.”
For instance, here is an example of after-inflation returns using different asset allocations from 2000-2002, a decidedly “bear market” period:
The table above seems to imply that a highly conservative portfolio is always desirable. Look at those positive returns! But when we take a long-term view (as younger investors generally should do), look at how those returns start going in the opposite direction:
Now do you see why time horizons and risk tolerance are so critical to your overall investment strategy? If you simply dive in and start buying stocks without thinking about the bigger picture, you could be charting a course to major disappointment. Think about how many investors dumped tons of stock in the early 2000’s (not just tech stocks, which were the problem, but ALL stock) due to nothing more than fear and overreaction? Had they hung on to some of it, they would’ve been far richer come 2004 and 2005 than they in fact were.
On the other hand, some people are simply not emotionally capable of carrying huge losses through a 2-3 year bear market to realize the gains that come after. If that’s you, it is better to learn that sooner than later. Keep these issues in mind as you build out your investment portfolio.
Moreover, if you have not yet determined your correct asset allocation, stop everything and do it now. Wasting time on minutiae (like the merits of this stock vs. that stock or the fees a mutual fund charges) is pointlessly distracting until you nail down this foundational issue first.
What are your thoughts on rebalancing your portfolio?