How and When to Rebalance Your Investment Portfolio

How and When to Rebalance Your Investment Portfolio

August 19, 2019

Why do people invest money?

People invest because they have extra money now and would like to do “something” in the future. Investing is synonymous with goals. You invest for an outcome.

Whether it's to pay for a house, start your own bakery, or have enough money for (potentially early) retirement. Your desires, combined with your risk aversion level, guide you towards an asset allocation — the % of stocks, bonds, real estate, commodities, and cash that will make up your overall portfolio.

• More stocks generally = more risky, more volatility, higher average returns
• More bonds generally = more safe and sound, less volatility, lower average returns

But how exactly do you pick an asset allocation, and when do you decide to adjust it?

We've all heard the saying “don’t put all your eggs in one basket”. Well, asset allocation applies this advice to investing. There are many issues to consider when deciding how many and what type of baskets you should stash these figurative eggs in. Here's what you need to know to pick the asset allocation strategy that works best for you.

1. Time horizon: longer the time horizon, more risk you can take
2. Risk tolerance: the stronger your stomach (and your finances), the more risk you can take

GENERALLY, a rule of thumb is you asset allocation to equities should be (120 - Age). So if you are 20 years old, you should be 100% stocks. (120-20) If you are 40 years old, you should be 80% stocks (120-40). etc.

Markets move

They swing rapidly in periods of high volatility (like we have seen in 2019), and sometimes they move consistently in one direction over longer periods of time. Your asset allocation WILL be thrown off by the market’s movement. It is guaranteed.

Basically, this means that even after you've chosen an allocation that's right for you, changing market prices will probably alter it.

For example, when the stock market is hot and increases in price, equities will become a larger % of your portfolio. This could expose you to more risk than you set out to take. Rebalancing takes care of this issue.

Rebalancing

Rebalancing can help keep your portfolio aligned with your target allocation and may help protect you from trading based on emotion. Large institutions use rebalancing to keep their risk in check (usually on a quarterly basis).

This means shifting your investments so that they realign with your targeted % set out in your initial asset allocation. Because, as mentioned, if you are 50% stocks and 50% bonds and then stocks go up in price faster than bonds do (which is generally what happens) you will be over allocated to stocks and will need to sell some of those and buy some more bonds to readjust back to 50/50. Lets look at an example:

On Jan 1 2019 you:

1. Purchased $5k of the ETF “VOO” (it was trading at $226, so about 22 shares)
2. Purchased $5k of the ETF “BND” (it was trading at $79, so about 63 shares)

This means that your total asset allocation is $5k stocks, $5k bonds, or 50/50. As of TODAY, VOO is trading at $265/share and BND is trading at $84/share. This means that you now have $5,830 in stocks and $5,292 in bonds, for a total portfolio value of $11,122.

Your new % of stocks/bonds is:

1. 52.4% Stocks
2. 47.6% Bonds

You can see how - over time - this difference will grow larger and more significant, leading to necessary rebalancing to keep risk in check. It also forces you to buy when things are low and sell when things are high. How?

In 2006, stocks were at all time highs and bonds were struggling to keep up. This meant that a person who started with 50% stocks and 50% bonds would have had to rebalance, selling some of their stocks at high prices and buying into their bonds at low prices.

In 2008/09 - those bonds went UP in value compared to stocks cratering. Rebalancing then, ditching the bonds at sky high prices, gave you the cash you needed to be able to buy stocks at rock bottom.

Combining this with the “glacier” approach (Linked Here) you can nearly guarantee that you will be setting yourself up for long-term investing success. Just note that there were years (74 recession comes to mind) when stocks and bonds fell AT THE SAME TIME!

I believe that is possible and could happen again in the future, so having a solid personal financial setup (spending less than you make, working hard to make more, etc.) will give you the capability to buy when nobody else can.

How to Rebalance

When talking rebalancing, there are two basic ways to go about it:

1. Periodic
2. Threshold level

Periodic rebalancing dictates that every X months/years, you rebalance back to the originally set allocation percentages. Most people do this once per year, some do it once every three months (quarterly). But this is a relatively effective way of managing your portfolio in a “set it and forget it” fashion. Coming back every 12 months or so and keeping the allocations in line.

Threshold rebalancing says “Hey, if stocks ever become more than 5% out of line from their target (Greater than 55% or less than 45% in our example above) we rebalance. This is obviously a more active approach to managing the portfolio because you have to be calculating your % allocation more often to make sure you are within threshold.

And that’s it!

I know that was quite a bit of information about a seemingly simple task - but knowing how to allocate and rebalance your portfolio is a critical skill in the world of personal finance! Utilizing this information can help you keep your emotions out of investing and keep you on the road to building wealth.

MDAS

If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @MakeDollarsAndSense, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!

P.S. New blog posts coming your way every Monday!

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