ALLOCATE YOUR ASSETS |
Asset allocation is a strategy, advocated by modern portfolio theory, for maximizing gains while managing risks in your investment portfolio. Specifically, asset allocation means dividing your assets among different broad categories of investments, including stocks, bonds, and cash equivalents.
Determining the asset allocation model — specifically the percentages of your portfolio allocated to each investment category — that's appropriate for you depends on many factors, such as how much time you have to invest, your tolerance for risk, and your investment goals.
For example, one investor might choose to invest 70% of her money in stock and stock mutual funds, 20% in bonds, 5% in REITs, and 5% in cash equivalents, while another might decide to split his money evenly between stocks and bonds only. These two portfolios will produce different returns, due partly to the difference in their asset allocation models. Research shows that, on average, 40% of the return difference between one portfolio and another is explained by the different asset allocations. So, if the first portfolio returns 5% more than the second, then on average about 2% of the difference (40% of 5%) is explained by the different asset allocations, while the remaining 3% difference (60% of 5%) is explained by security selection, timing, and fee differences.
Setting your asset allocation is the single most important decision you can make as an investor. (That is, once you've decided to invest at all!) That's because, on average, investors don't beat the market: In general, their portfolios don't perform better than the overall market, regardless of the individual stocks, bonds, and mutual funds they select. This means that for the average investor, the asset allocation mix they choose — what percentage of stocks, bonds, cash, and other asset classes they include in their portfolio — accounts for 100% of their return level.
Your allocation strategy can make a major difference to your investment return and your level of investment risk. That's because each asset class behaves differently from the others, and the percentage each accounts for in your portfolio affects the overall performance.
For example, while stocks can be the most volatile investments over the short term, they have historically outperformed every other asset class over longer terms of 10 years or more. Bonds, on the other hand, often provide a reliable income, but over time have historically underperformed stocks. And cash equivalents, though comparatively safe and extremely liquid, usually provide very modest returns.
For an investor, this means that the greater the percentage of stocks in your portfolio, the greater your potential for higher returns over the long term. However, the downside is that the more stocks you own, the greater your potential for short-term losses.
The extent to which asset classes perform similarly to one another is called correlation. Correlation measures the movement of one asset class relative to another, and ranges from -1 to +1. A correlation of -1 means that the two assets move in opposite directions, while a correlation of +1 indicates that two assets move together. Most traditional asset classes fall into the moderately positive range in relation to each other. For example, from 1926 to 2011, the correlation of long-term corporate bonds to large company stocks was .17, or somewhat positive. For the same period, the correlation of US Treasury bills to small company stocks was -.07, or slightly negative. Holding investments with low to negative correlations to one another can reduce the overall volatility and risk within your portfolio.
Another reason why asset allocation is important to managing risk and return is because different asset classes typically react differently to changing economic conditions. For example, a growing economy may produce strong stock returns but may cause bond returns to slump, and vice versa. On the other hand, when interest rates are on the rise, bonds may outperform stocks for a period of time.
By spreading your investments across different asset classes, you may be able to limit, or offset, potential losses in one asset class with stable values, or even gains, in another.
For investors seeking long-term growth, stock and stock mutual funds are usually the meat and potatoes of their investment portfolio.
Although your stock investments can increase and decrease significantly in value over the short term, the longer you stay in the stock market, the more likely you are to come out ahead. That's why most financial experts agree that the younger you are, the more you should stress stocks in your portfolio. If you begin investing early, you have time to ride out the inevitable ups and downs in the stock market.
Bonds are also known as fixed-income or income-producing investments because when you buy a bond, you receive interest payments on a regular schedule. And the bond issuer promises to pay back your principal, or original investment, when the bond matures.
Cautious investors, or investors approaching a major financial goal such as retirement, may allocate more of their assets to bonds than to stocks not only because bonds pay regular income, but because their prices are usually less volatile than stocks.
But that doesn't mean that bonds are invulnerable to market changes, or that they are always risk-free investments. Bond prices change in response to supply and demand, which are driven by changes in interest rates. The prices of some bonds, such as zero coupon bonds, can be highly volatile in the secondary markets. And high-yield bonds, sometimes called junk bonds, can be very high-risk investments because of the danger that the bond issuer will default, and fail to make its interest payments, or even fail to pay back your principal.
But a portfolio heavily weighted in high-quality corporate bonds, municipal bonds, and Treasurys, will almost certainly fluctuate in value less than a portfolio that is concentrated in stocks. The trade-off is that over the long term high-quality bonds generally provide more modest rates of return than stocks.
Cash and cash equivalent investments, such as money market funds, certificates of deposit (CDs), and Treasury bills, are low-risk investments that pay interest. Their short terms and stable values mean they generally provide smaller returns than the other major asset classes. But they have one big advantage — they're highly liquid, so you can turn them into cash at any time without a major loss in value.
The rate of interest that cash investments pay is usually not enough to offset the effects of inflation, or the gradual erosion of the buying power of your money. So if you're seeking long-term growth, you'll want to limit the amount of money you allocate to cash equivalents. Nonetheless, cash investments can play a role in a well-balanced portfolio — to provide liquidity to meet shorter-term goals and emergency expenses, as a holding place between longer-term investments, or to provide a buffer against the fluctuation in value of more volatile securities.
Even if you keep your emergency cash fund stashed separately, it's smart to allocate at least some of your investment assets to cash, so you have money on hand when new investment opportunities arise. Even investors who allocate their portfolios very aggressively — say 85% or 90% stock — often allocate the balance of their portfolios to short-term cash equivalents for this reason.
Futures and options are called derivative investments, because their value depends on the value of an underlying investment, such as a stock or commodity — or raw material. You can think of futures and options as bets that the price of the underlying investment will go up or down by a certain amount over a certain period of time.
You can buy futures contracts on agricultural or financial products, natural resources, interest rates, and currency values. You can buy options on stocks, stock and bond indexes, interest rates, currency values, and futures contracts.
One appeal of derivatives is that you can use leverage, or a small amount of your own money, to have control over something of greater value. But derivative prices are volatile, which means you can lose or make a good deal of money very quickly if you use them in this way.
Because timing is critical, derivatives, especially futures, are probably less well suited for buy-and-hold investors. But for experienced investors who are comfortable making day-to-day trading decisions, derivatives — and options especially — may be a suitable way of adding variety to an otherwise well-balanced portfolio. In fact, you can use options conservatively to increase your income or limit your risk from falling prices in your portfolio, or more speculatively, for the leverage they provide.
When you buy an option, you purchase the right to buy or sell a specific quantity of the underlying investment at a set price, within a particular timeframe. Unlike a futures contract, you're not obliged to buy or sell — you simply lose the amount you paid for the option. But if your analysis of the direction of the market is correct, you stand to make a profit.
When you sell an option, you must fulfill your obligation to buy or sell the underlying investment at an agreed upon price, if the buyer exercises the option. The biggest risk occurs if you sell an option on an underlying investment that you don't own. That means you'd have to buy it at a market price to meet your obligation to sell, which could cost you a bundle.
More conservative investors may buy or sell options to help protect the value of their portfolios from falling prices, to lock in a favorable purchase price, or to make some immediate income. Speculative traders like the leverage, or opportunity to have a potentially larger gain than they could achieve by owning the underlying investment. Of course, they could have larger losses too, but that's the risk they're willing to take.
When you buy or sell a futures contract, you're making an agreement to buy or sell a product at an agreed-upon price by a specific date in the future. Since product prices can change in the meantime, you stand to gain or lose money on the deal. But what most investors do instead is buy an offsetting contract — for example, one that obliges them to sell if their original contract obliged them to buy, hoping to make money on the changing value of the contract.
You can build your investment portfolio without looking further than stocks, bonds, and cash.
But there's a range of other investment opportunities that can help you meet your financial goals. Some of them, like buying real estate, may have the added advantage of providing you with a place to live. And increasing numbers of investors are augmenting their portfolios with alternative investments, such as real estate investment trusts (REITs), inflation-protected securities, and hard assets.
One of the benefits of adding alternative investments to your portfolio is that they typically have low correlations with more traditional investments. This means that their values usually don't move in tandem with more traditional investments — reducing the volatility of your portfolio.
For example, hard assets, such as timber, precious metals, and energy, tend to have low correlations with both stocks and fixed-income securities. So hard assets may gain value when stocks and bonds hold steady or decrease in value, and vice versa.
Some alternative investments are well suited to conservative or moderate investors, while others are more appropriate for investors who can tolerate a fair amount of risk. It's important to understand the unique characteristics of the investment you're considering and how that investment fits in with your overall allocation strategy.
Though it may seem counter-intuitive, the addition of a high-risk asset to your portfolio may reduce your total portfolio risk if the high-risk asset has a low correlation with your other investment assets. In this way, you can lower your portfolio risk while at the same time increasing your potential return.
There are many ways you can invest in real estate. Of course, if you own your own home, that's a major real estate investment. But there are a number of other investment opportunities in real estate. You could, for instance, become a partner in a construction project, develop an empty lot, buy rental property, or participate in a real estate investment trust (REIT) or limited partnership.
Real estate can be appealing since it can provide a hedge against inflation, make you eligible for a variety of tax deductions and exclusions, and increase in value dramatically in some markets. The downside is that real estate may be hard to sell when you need to, especially at the price you want.
Real estate investment trusts (REITs) are an increasingly popular and accessible way to invest in real estate. These publicly traded trusts and associations trade like stocks but work like mutual funds. Your capital is pooled with other people's to invest in apartment and office buildings, shopping centers, industrial buildings, hotels, and other real estate ventures. The trust makes the investment decisions, and its shares trade on the stock market.
There are three types of REITs:
A limited partnership is a financial affiliation of a general partner and a number of limited partners that usually invests in a particular type of income-producing property, such as shopping malls or low-income housing. What makes the partnership limited is that everyone but the general partner has limited liability — which means they can lose only their initial investment if the project fails.
Some limited partnerships are public, which means you can participate by buying shares through a brokerage firm. Others are private and are usually restricted to high net worth individuals.
While strictly a type of bond, the unique characteristics of Treasury inflation-protected securities, or TIPS, puts them in an asset class of their own.
TIPS are inflation-indexed bonds and notes that are issued by the US Treasury. Like traditional Treasurys, TIPS pay a fixed rate of interest. But what makes TIPS different is that the principal value of the bond, to which the interest rate is applied, is pegged to the current rate of inflation. So if inflation rises throughout the term of the bond, so will your interest payments.
For example, let's say you buy a $10,000 inflation-indexed bond with a yield of 3% per year. If the inflation rate is 4% the first year you hold the bond, the bond principal will increase to $10,400 and your first annual interest payment will rise from $300 to $312 (or 3% of $10,400). On the other hand, during a rare period of deflation, your interest payments would drop.
At the end of the bond's term, you are repaid the inflation-adjusted principal. So, if you bought a $10,000 bond and inflation rose 8% during the life of the bond, you would receive $10,800 at maturity. However, in the case of deflation, you never receive less than what you paid for the bond. So if deflation occurs and decreases your interest payments, you'll still receive your full principal back at maturity.
While traditional bonds pay slightly higher rates of interest, the real rate of return on TIPS, after accounting for inflation can outpace traditional bonds.
Another advantage of allocating some of your assets to TIPS is that they can lower the overall volatility of your portfolio. That's because TIPS have a low correlation to other types of bonds, since they respond differently to inflation. They also have a lower correlation to stocks than traditional types of bonds. This means that their values don't necessarily move in tandem with other, more traditional, types of investments.
Another alternative to traditional bonds are convertible bonds. These hybrid investments give you the option of exchanging the bond for a specified number of stock shares at a set price.
Convertible bonds can provide protection from interest rate risk, since you can convert your bond to shares if interest rates and inflation rise. Another benefit is that convertible bonds have relatively low correlations with traditional bonds, so they can be used to balance a fixed-income portfolio. However, their correlation with equities is high, making them less useful in a portfolio tilted toward stock and stock mutual funds.
You can purchase convertible bonds through a broker or choose a mutual fund that invests in them.
For investors who are attracted to hedge fund strategies but can't afford the extremely high minimums or long-term financial commitment that these funds require, market-neutral mutual funds may offer an alternative. These funds follow a controversial investment strategy — alternately called market-neutral, zero beta, and long/short portfolio investing — that is designed to maintain average annual returns that are a few points above the return on three-month US Treasury bills, regardless of whether the market is going up or down. The goal is to provide a measure of stability within your investment portfolio.
Market-neutral fund managers use computer programs to evaluate and rank possible investments quantitatively, analyzing price-to-earnings ratios, yield, volatility, earnings growth, and other factors. The fund then buys the stocks ranking at the top, and sells short the ones at the bottom.
Because meeting the fund's goals depends so heavily on accurate assessments of future market movements, some experts consider market-neutral funds more speculative than funds that follow a more conventional trading approach.
There's no single asset allocation that's right for every person or situation, and no allocation model that's ideally suited for every phase of your life. Your age, your financial goals (and how long you have to meet them), your risk tolerance, your current financial wealth, and your "human capital" will all play a role in helping you determine your asset allocation.
Your current financial wealth is what you currently own — savings accounts, real estate, hard assets, etc. Your human capital is defined as the present value of your future wages dedicated to retirement. When developing an asset allocation, you want to consider both of these to quantify your total wealth.
Think of your financial wealth and human capital as the portfolios that you need to balance against. Your human capital portfolio is much like a bond portfolio. Just as you work and get a regular paycheck, a bond provides a regular stream of income. To balance this conservative portfolio, an investor with a great deal of human capital would invest his money more aggressively. Financial wealth, on the other hand, is subject to market volatility and is therefore more risky than human capital. An investor with a great deal of financial wealth in comparison to human capital would want to balance out that financial wealth with conservative investments.
Typically, as people age, financial wealth rises while human capital falls. Your amount of human capital is larger when you're young in proportion to your financial wealth, because you have a long time horizon to work and you haven't had the time to accumulate a great deal of financial wealth. Over time, however, investors accumulate more assets, but their earnings horizon declines. As your proportion of financial wealth to human capital changes, so should your asset allocation. Greater financial wealth relative to human capital should result in a greater amount of investments dedicated to a conservative asset allocation versus an aggressive asset allocation.
Your financial goals — and how long you have to meet them — will play an important role in helping you decide how to allocate your investments.
For instance, let's say you're expecting a baby. Then paying for a college education may become an important financial goal. To make the most of the 17 or 18 years until your child enrolls, you might emphasize growth investments, such as stock and stock mutual funds, in your portfolio. On the other hand, if you're investing to make a down payment on a home in the next two or three years — whatever your age — you may want to reduce your exposure to volatile investments, such as stocks.
If you've got 20 or 30 years until retirement, you may decide to allocate all of your portfolio to growth investments, with the understanding that you'll have time to recoup any losses to your principal. But, the closer you get to retirement, the larger the percentage of your portfolio you may want to allocate to investments that will provide a reliable source of income, such as high-quality bonds, or to investments that provide more liquidity, such as cash equivalents or short-term bonds.
In general, the further away you are from your financial goals, the more risk you can afford to take. And as your personal life or financial goals change, you may need to reevaluate your asset allocation.
It's not enough that your asset allocation plan makes sense given your age and your financial goals. It also has to be comfortable, to feel right. If changes in the value of your portfolio are keeping you awake at night, then you might want to consider shifting to a more conservative asset allocation with a greater emphasis on less volatile, fixed-income securities, such as high-quality bonds. On the other hand, if you're a risk taker by nature, you may be comfortable allocating most of your portfolio to volatile investments that have a good chance of increasing in value in the long run.
Your risk tolerance stems from a variety of things, including your age, personality, personal experience, and financial circumstances. For example, if you're approaching retirement, have burdensome financial responsibilities, or have lived through major economic upheaval, such as a massive recession or currency devaluation, chances are you may be a more risk-averse, or conservative, investor.
On the other hand, if you're young, earn a high income, have few financial responsibilities, and have seen little in the way of economic hardship, you might be inclined to take more risk.
Most experts agree that you should take as much risk as you're comfortable with — and that makes sense given your age and your financial goals. But taking risk doesn't mean putting all of your money into highly speculative investments. What it does mean is allocating as much of your portfolio as possible for long-term growth — in investments such as stocks, stock mutual funds, and options.
Volatility poses the biggest investment risk over the short term. But if you can wait out downturns in the market, chances are the value of a diversified portfolio will rebound. In fact, over historical periods of 20 years or more, stocks — usually the most volatile investments over the short term — have always increased in value.
Almost every brokerage firm, financial services company, and bank will recommend a variety of allocation models based on different risk profiles, from the completely risk-averse, or very conservative, to the very aggressive. Companies may revise their recommendations from time to time, though rarely dramatically, as the outlook for the financial markets changes.
For instance, in a growing economy, brokerage firms may put a heavier emphasis on equities in many of their allocation models. On the other hand, in a contracting economy, or during a recession, they may encourage investors to put a little more money into fixed-income securities by emphasizing bonds in their allocation recommendations.
Similarly, when interest rates are high, financial companies may focus more on bonds in their allocation models. But when interest rates are low, stocks may take center stage.
This doesn't necessarily mean you should change your allocation based on your — or the experts' — predictions on the direction the markets may be headed. For one thing, it's impossible to predict the direction of the markets with certainty, even for investment professionals.
Not only that, but the economy tends to grow and contract in cycles. In the past, a period of growth has always been followed by a period of contraction. If you're invested for the long term, chances are that the impact of any short-term or cyclical change in the economy will be counter-balanced or offset by the reverse trend.
Rather than tampering with your allocation based on market trends, you're probably better off choosing an allocation strategy that works for you and sticking with it — at least until your goals or your life situation changes dramatically.
You want to choose the asset allocation model, or plan, that has the highest likelihood of helping you achieve your financial goals at a level of risk you're comfortable taking. Then, as your life situation and tolerance for risk changes, or as you get closer to reaching a particular goal, you'll want to adjust your allocation.
You can develop your own asset allocation plan based on the models recommended by your broker, 401(k) provider, or financial services company for investors of a similar age and risk tolerance. Even better, you can work with a financial adviser to determine an initial allocation model and refine it as time goes by.
Most experts agree that in order for your investments to grow at a rate that significantly outpaces inflation, you'll need to allocate a significant portion of your portfolio to stocks.
Aggressive investors are willing to accept considerable volatility in their portfolios in the short term, have little need for current income from their investments, and have a significant number of years ahead of them to meet their financial goals. They might allocate 80% or more of their portfolio to stocks and other potentially volatile investments such as options and REITs.
Since the focus in an aggressive allocation model is growth, bond investments play only a supporting role to help lower volatility, while cash investments provide liquidity for emergencies and other investment opportunities.
While an aggressive allocation model isn't for the faint of heart, history has shown that this approach, combined with a well diversified portfolio, and the patience to stick to a long-term buy-and-hold investing strategy through inevitable market downturns, can be the most profitable in the long run.
A moderate allocation model — in which you invest about 50% to 70% of your portfolio in stock and stock mutual funds — can help you balance some of the volatility of stocks with the more reliable income provided by bonds and cash equivalents. The trade-off is that this approach will probably not provide the same level of growth in the long term as a more aggressive strategy.
A moderate allocation plan might be appropriate for investors who want to buffer short-term volatility in their portfolios, need to balance near-term and long-term financial goals, and have less than 10 years until retirement.
If you're not a risk taker by nature but are willing to tolerate some volatility in your portfolio, a moderate allocation model may be suitable in almost any circumstance or financial situation.
And keep in mind that what might be considered a moderate, or even conservative, approach at 25 years of age — say 70% stocks, 20% bonds, and 10% cash — would be quite an aggressive approach by the time you reach 60.
In a conservative allocation model, income-producing investments, such as bonds, take center stage. Stock and stock mutual funds may play a more minor role to provide modest growth to offset some of the eroding effects of inflation. For investors seeking long-term growth, a conservative allocation model probably wouldn't provide enough exposure to stocks.
But sometimes a conservative approach may be appropriate. For instance, if you have major financial responsibilities, such as large amounts of money invested in your own business, it might make sense to take on less risk in your investment portfolio. Or if you're retired or expect to retire in the near future, it may be unwise to put a lot of your assets at risk in volatile securities at this stage in the game, when your portfolio may not have time to recover from a market downturn.
However, some experts recommend that even retired people allocate a substantial portion of their portfolio to stocks, since many people may spend 30 or even 40 years in retirement.
Very short-term financial goals, such as buying a home within the next year or two or sending your high school senior to college, call for an allocation strategy focused on capital preservation. That means keeping most of your money available and safe in high-quality fixed-income investments and insured accounts.
If you don't want to give up all the growth potential of stocks, you might keep a small portion of your portfolio allocated to that asset class. However, you run the risk that you'll have to redeem your shares at a loss if the market goes down. You can manage this risk to some extent by deciding ahead of time that you'll sell when a stock increases or decreases in value by a fixed amount, say 20%.
The extent to which cash equivalents — which are usually very safe and often even insured — bonds, and stocks may be represented in your short-term portfolio depends not only on how soon you'll need the money, but also on how long the money needs to last.
For instance, if you're making a one-time payment — such as a down payment on a house — you'll want to allocate for maximum liquidity, perhaps exclusively in cash equivalents such as CDs and T-bills that are scheduled to mature when you need the cash. However, the picture may change if you'll be drawing on the assets over a period of time — over the course of your child's college career, for instance. Then you may want to allocate the money you'll need up front in insured investments, and spread the rest among longer-term bonds, and perhaps even in some stock.
Keep in mind that a short-term allocation model will provide little, if any, insulation against the eroding effects of inflation and taxes on your portfolio over the long term.
If you have a variety of accounts — for instance, a 401(k) or similar employer-sponsored retirement plan, an IRA, and a separate taxable account — you'll want to consider not only how to allocate the assets within each account, but also how your different accounts can work together to help you meet your financial goals.
For example, if your employer-sponsored retirement plan and IRA are invested primarily in stock and stock mutual funds, you may want to seek balance by allocating a larger percentage of your taxable account to tax-exempt municipal bonds and Treasury bills.
Another consideration is whether you'll be eligible for a guaranteed, fixed-income pension when you retire. If that's the case, you may be in a position to assume greater risk in your own investment portfolio, with the goal of achieving higher returns. That might mean weighting your asset allocation more heavily towards stocks, as opposed to fixed-income securities.
Throughout the years leading to retirement, investors are focused on accumulating and growing their financial wealth. During this stage of life, the main risk they face is market risk — the risk that they will lose money due to market downturns. Once investors enter retirement, however, they face not only market risk, but also mortality risk.
Mortality risk is the risk of you or your spouse outliving your money. Investors need to keep in mind that the average life span is just that — an average. Fifty percent of people will have life spans longer than the average and fifty percent of people will have life spans shorter than the average. If you're not eligible for a pension and you're concerned about outliving your money, you should consider an annuity.
There are many different types of annuities, but the general idea is that you give an insurer a certain amount of money and in return the insurer provides you with regular payments for either a certain period of time or the span of your life. When added to a diversified portfolio, annuities provide a floor for your income stream. An annuity ensures that at least some amount of money will be flowing into your pockets for the rest of your life.
Your financial adviser can help you assess which financial products and asset classes to include in your allocation to help you achieve your financial goals.
If juggling your investments to keep your allocation mix the way you want it seems complicated, it doesn't have to be.
For instance, let's say you've chosen an allocation model of 60% stocks, 30% bonds, and 10% cash. Then each time you have money to invest — say $1,000 — you could put $600 into a stock mutual fund, $300 into a bond fund, and $100 into a money market mutual fund toward the purchase of your next CD or T-bill.
While your overall portfolio may never be allocated as precisely as a hypothetical model, perfection isn't what you're after. And by adding money to all three investment categories in approximately the proportions you've decided on, you've made it easier to stay on top of allocating your assets.
Investing with a mutual fund network may make it easier to keep your allocation on track.
Usually offered through a brokerage firm, fund networks give you access to thousands of different funds from most of the major fund families. With a small initial investment, you have access to all the funds within the network. That means you can allocate your investment money across a range of different investments — say a variety of stock, bond, and money market funds — usually without the account minimums and additional fees of separate accounts. But before you choose a network, compare the transaction and annual fees, which can vary from one network to another.
Asset allocation isn't something you need to worry about every day. On the other hand, it isn't something you can do just once and forget about until retirement.
As the value of your investments increases or decreases, or your life changes, you'll probably want to modify your initial asset allocation, or bring your actual portfolio in line with the one you intend to own.
1. As you get closer to retirement, you may want to shift some of your assets out of potentially volatile growth investments, such as stocks, into income-producing investments with more stable values.
2. You may want to rebalance your allocation in response to major life events that have an impact on your financial situation, such as getting married or divorced, having children, or changing jobs.
3. If market performance increases or decreases the value of one asset class so that your actual portfolio allocation is significantly different from the allocation you selected, you may want to realign your holdings to get them back in balance.
Many financial advisers suggest you review and rebalance your portfolio once a year. Others say that you can ignore imbalances unless the value of any class exceeds the allocation you originally selected by 15% or more.
Changes in the markets can make different assets grow at different rates. Over time, the ones that grow more quickly will make up a greater percentage of your portfolio than you originally planned. For instance, an asset class that initially made up 25% of your portfolio might, at some point, increase to 40% while another asset class may shrink from 25% to 10%.
For example, investors who had lots of money in small technology companies in 1998 watched the value of those investments balloon in 1999 to a disproportionately large percentage of their portfolios. But when these stocks plummeted in 2001, holdings in these small companies represented a substantially smaller percentage of their portfolio. Provided your goals and your risk tolerance haven't changed, having a lopsided allocation can interfere with your plans for meeting your financial goals. Without reallocating, you may find yourself with a portfolio that has more risk or a smaller long-term return than you're seeking.
Whenever your investment goals change, you should review your asset allocation to make sure it will continue to help you reach your financial goals. For example, after you've been investing to help make your down payment on a house, you may want to switch your focus toward saving for college and retirement. You should make sure your investments and allocation reflect this change in goals.
You can rebalance your portfolio in different ways. All these approaches work, but you may feel more comfortable with one than another.
1. One way to rebalance is to sell off a portion of the asset class that has increased most in value and reinvest those profits in the lagging asset class.
2. Or, you can change the way your future contributions are allocated, putting more money into the lagging asset class until things are back in balance.
3. You can also add new investments to your portfolio in the lagging asset class and funnel your contributions to those investments.
While all three methods work, many investors are uncomfortable with the first approach since it seems illogical to sell investments that are doing well to buy those that are not. Remember, though, that no asset class is the strongest performer year in and year out. It may be smarter to sell at a high price than to watch the value of an investment drop.
If you're rebalancing a taxable investment portfolio — by selling investments that have increased in value — to buy investments that have grown more slowly, you'll owe capital gains tax on the profits you realize. That means if you rebalance your portfolio in this way too frequently, you could end up owing the government significant amounts of tax.
A more tax-friendly approach may be to reallocate the amount being directed into slower growing investments or make additional contributions into that category.
In addition to the possible tax impact of rebalancing, you should consider potential transaction fees unless they are included in a fee-based adviser account. Your financial adviser can help you identify rebalancing strategies that minimize trading costs.
You may have heard the phrase, 'the only constant is change itself.' Nothing could be more true about the world of investing. In fact, the only constant in the financial markets is that their values will go up at some point just as surely as they will go down.
Your first line of defense in dealing with this uncertainty is knowledge. Safety is achieved by understanding all of the risks of an investment, not just the obvious ones.
Your next line of defense is asset allocation — the first and most important step in building a diversified portfolio.