This is the 15th article in a series that will discuss and explain basic investment concepts in hopefully an understandable and meaningful way. Whether you work with an investment advisor or choose to do your own investing, there are some things you need to know to be successful. Here is my take on what those things are.
What is re-balancing, and why should I be doing it? This is a very good and very important question. You have wisely chosen an appropriate investment allocation. Let’s assume it is 60% stocks and 40% bonds. The 60% stock position is broken down into 25% U.S. blue chip stocks, 25% international blue chip stocks and 10% emerging market stocks. The 40% bond position is broken down into 20% U.S. investment grand bonds, 15% international investment grade bonds and 5% U.S. high yield bonds. The mutual funds and/or exchange traded funds you have chosen to fill out these positions are passive investments (we talked about that in my last article) that mimic the benchmark index for all of these investment categories. So far so good. You plan to be a long term investor and leave this allocation alone to do its work for you. This is a good thing. But there is one more thing that you have to do on a regular basis to make all of this work. Re-balance!
This asset allocation strategy has an expected return for a certain level of risk. If you are asking me, I think you should hope for a long term return of somewhere between 5% and 7% per year with a standard deviation of 11%. This means a certain amount of up and down excitement comes with this portfolio.
Let’s talk about the big picture. You invest some money in this portfolio, and it starts out 60% stocks and 40% bonds. You check your portfolio in six months. It has grown in value due to some good stock performance and you now have a 70% stock and 30% bond portfolio. What should you do? The answer is easy. You did not invest in a 70/30. That was not your plan. If you bought a 60/40 portfolio and it is now 70/30, you have to sell 10% of those stocks and add the proceeds to that 30% bond position to get back to a 60/40. If 60/40 is your plan, you need to stick with your plan. Period. By selling 10% of those stocks, you took some profits (sold high). By adding those proceeds to the bonds, you bought something that was down in value. Hmmmm! You sold high and bought low! And you didn’t have to guess about it. You reacted to what the markets gave you. This is how it is supposed to be. Whenever an investment category does great for a period of time, it is eventually due to not do so well. Whenever an investment category does poorly, it is due sometime to turn and do well. Re-balancing takes advantage of the ups and downs of the different categories of investments in your portfolio.
Forget the temptation to do nothing with the 70/30. It has more risk than you were comfortable with to begin with. And don’t even think about selling some bonds and adding to that 70% stock position. Sooner or later, and probably sooner, you will make a big mistake that will cost you. Get excited about buying some stocks that just got killed (buy low). What an opportunity!
How often should I re-balance? For most folks, once a year is probably fine. For those who pay a bit more attention to their investments maybe no more than quarterly.
How do I add money to my portfolio? Which investments should I add to? Great question with an easy answer. Adding some money to your portfolio is a great opportunity to rebalance back to your initial proportions. A little math is involved in this process – the time you take will be worth it.
How do I take money out of my portfolio? What do I sell? Piece of cake! Any withdrawal from the portfolio is also an opportunity to re-balance back to your initial proportions. It takes all the guesswork out of investing! It’s a wonderful thing! This is what professional investors do.
Michael J. McNamara, Ph.D., CFP®
CERTIFIED FINANCIAL PLANNER™
Disclaimer: Any financial advice in this article is intended to be generic in nature. Readers should consult with their own financial advisors before implementing any advice or suggestions above.