Rebalance Your Asset Allocation Guide
Earn More by Rebalancing Your Asset Allocation
Raise your had if you want an extra one quarter percent return on your portfolio every year? It takes about an hour and you can get this extra return every year. I know, it’s not much, but with interest rates in the basement, every little bit helps.
Before you learn how to rebalance your asset allocation, let’s review a bit of investing background.
What is Asset Allocation?
“Don’t put all of your eggs in one basket.”
This old adage describes the best way to boost investment returns. Diversify your investments among stock and bond index funds and you’ll cushion the volatility and boost returns. Imagine, over the last decade if you invested only stocks, your returns would have been in the low single digits. If you added some bonds to your portfolio, your investment returns go up a few percent.
Modern investing portfolio theory recommends determining your risk profile and then divvying up your portfolio in line with your risk level. In other words, if you can handle a bit more volatility in your investment returns, you want more stocks in your portfolio. Terrified of the cyclical ups and downs in your investment value, invest a greater percent in bonds.
Asset allocation is the investors personal decision about how to divide up your investments among basic asset classes. In general, investors divide their assets between stock and bond type investments. Younger folks, with more time until retirement and a longer working life frequently benefit from an asset allocation more heavily weighted toward stock investments. A guy in his 50’s facing retirement in fifteen years and risk averse, may choose 55% stock investments and 45% bond investments. A young woman with a high paying secure job and a high risk tolerance chooses 75% stock investments and only 25% bonds.
Following is an image of 34 year old Carter’s, moderately aggressive investment portfolio:
- 33% in a broadly diversified United States stock index fund
- 33% in a broad diversified International stock index fund
- 34% in an inflation protected bond fund
Rebalance and Increase Returns
A recent Wall Street Journal article reported that investors who regularly rebalance their investment portfolios increase their returns. Another solid reason to rebalance is to minimize risk. Even the most aggressive investor would prefer less investment volatility.Free micro investing book and wealth tips!
What is rebalancing?
Consider Carter’s portfolio above. The investor’s asset allocation is equally divided among three mutual funds. After one year, due to changes in value his portfolio looks like this:
- 36% in a broadly diversified United States stock index fund
- 26% in a broad diversified International stock index fund
- 38% in an inflation protected bond fund
During the year, the U.S. stock market increased 9% so Carter’s U.S. stock index fund increased to 36% of the overall portfolio. With the economic troubles in Europe, the international fund fell 23%. Finally, with the decline in market interest rates, the inflation protected bond fund increased in value 13% and grew to 38% of his total investment portfolio.
The goal of rebalancing is to return the proportion invested in each asset class to the investor’s original percentages; 33% in the two stock funds and 34% in the bond fund.
How to Rebalance Your Asset Allocation?
When considering how to rebalance your asset allocation, there are several alternatives to rebalancing. The investor can simply sell off the assets which have increased above the target level and buy more of those that are beneath the target. In other words, the investor would buy more of the International stock index fund and sell of shares of the bond and U.S. stock funds so that the percentages return to the original proportions.
Another option is to invest new monies into the asset class that is below the target. In this case, it’s the International stock index fund. That way the International stock index fund would increase as a percent of the total portfolio until returning to the desired allocation.
How Often to Rebalance?
Once or twice a year is enough to rebalance. It’s unnecessary to undergo rebalancing more frequently. The reason for rebalancing is to buy low and sell high. The investments that have fallen in value are bought (buy low) and those that appreciated are sold (sell high).
Personally, I check both my own portfolio and those that I manage several times per year, but rarely rebalance more than once per year. The research supports rebalancing once or twice a year to boost returns about .25%.
Is it worth an hour or so to increase returns and reduce your portfolio’s ups and downs?
How often do you rebalance? What are your investing thoughts?
A version of the article was previously published.