How To Rebalance Your Portfolio

If you have diversified your investments and come up withRebalancing Portfolio an allocation model, you know how you want your portfolio to look. Over time, though, some investments do better than others. Eventually, those stocks that were supposed to be 15% of your portfolio will end up closer to 20%. So what are the best tips for rebalancing when that happens? First, if you are regularly adding to your account, a patient strategy of shifting how you invest new money is your best approach. Each time you add money to your account, invest the new cash in one of the asset classes that is below your targets. One deposit may be enough, or you may need to continue adding to the below-target class for several months.  When that class is on target, switch your investing to another below-target class. Take your time; the balance does not have to be perfect so long as you are moving in the right direction.

If you are not regularly adding to your account, you will need to sell some of your holdings from an above-target asset to buy into the asset class that is below your target.

Notice that both approaches mean selling or passing on shares of your best performing stock or fund—the one you've been thrilled with—in order to invest more in the dud that's been disappointing you. It might feel like a mistake, but this effect is part of what makes asset allocation work. You will find that following your plan helps you avoid the trap of buying the stuff that has already peaked and forces you to purchase the low-performing investments before they start their own rise in market cycle.

Asset Allocation 101

Capital Growth
Capital Growth

In my opinion, asset allocation has had more impact on average investors over past the two years than any other topic in investing. Why? The whole idea of asset classes used to be foreign to anyone but the professionals, even though they serve as the foundation of what we do. Fortunately, even low-cost stock trading platforms and 401k's started adding new online tools a few years ago to help investors choose a standard asset allocation model.

If you don't have access to one of these tools, you want to customize your existing account, or you just want to understand how asset allocation work, this article is for you.

Let's start with the what and why of asset allocation.

Stocks and Bonds

To create an asset allocation model, always start by splitting your model between stocks and bonds. The value of bonds generally doesn't fluctuate as much over time, and they usually produce income (interest payments). This makes them a great investment base, but you aren't going to be bragging about how much your investments are up with an account full of bonds.

Stock prices, on the other hand, can fluctuate wildly. This can be disastrous in a recession, but it does give you the opportunity for some real gains in a good economy.

Retirement Planning
Retirement Planning

How much of your investments do you want in stocks? Most of the advice out there is focused on your age—the American Association of Independent Investors figures that "Moderate" investors fall between about 35 and 55 years of age, with more aggressive youngsters below and conservative retirees above. The truth is that this isn't really about your age—it's about your timeline and how much unpredictability your sanity can handle. If you plan on letting your money sit in the account for 30 years or more, you can afford to be aggressive, no matter how old you are. Likewise, a 20 something who might need the money out in ten years should be thinking more conservatively.

If you consider that the AAII recommends a 70%/30% split between stocks and bonds for "moderate" investors, you can see how aggressive investors will often settle for only 10% or 15% of their portfolios in bonds. The newly-retired will often have as much as 50% of their portfolios in bonds.

As you can imagine, eventually shifting your portfolio over is essential here. As you gradually get closer to the time when you'll need your money, you will want to put new deposits into bonds. If you are not adding to your account take advantage of moments when the stocks are high to sell some of those off and move them into bonds.

What Are the Asset Classes?

You now have come up with your guideline for how much goes into stocks and and how much into bonds. Some investors stop right there with their allocations—it's easy now to find a mutual fund that has a full range of stocks and a similar bond fund and call it done. Most people, though, like to break things out more precisely within those stock and bond categories.

Every investment manager has her own rule for which asset classes are necessary for a well-balanced, basic portfolio. My own basic portfolio models rely on just six asset classes (though we often make adjustments for a particular client's circumstances). The American Association of Independent Investors uses the same classes but adds in Emerging Markets as a standard class (note: we aren't opposed to emerging markets but the extra fund expenses can cancel out the extra gains you are looking for with these). Here are the six classes listed very loosely in order of risk—the classes considered most volatile are at the top and the most steady at the bottom:

  • International Stocks
  • Small Capitalization U.S. Stocks
  • Mid-Capitalization U.S. Stocks
  • Intermediate Term Bonds (7 to 10 year duration)
  • Short Term Bonds (1 to 3 year duration)

I've included the AAII's three allocation models at the bottom of the post, but you can adjust these to your circumstances. So, if you have created a nice moderate split of 70% and 30% stocks to bonds, you can make you portfolio that much more aggressive or steady with some fine tuning, by say, using more Small Cap stocks to get more adventurous.

What To Expect From Your Investments

Now that you have a plan coming together for your own personal asset allocation model, it makes sense to think about how things might play out over time.

The chart below is from one of my favorite bloggers, Ben Carlson, who writes at A Wealth Of Commonsense. (Note: you can find the 2016 update from Carlson at this link

asset allocation quilt wealth of common sense
asset allocation quilt wealth of common sense

Carlson calls this his asset allocation "quilt." If you look carefully you will notice he has 10 asset classes whose performance he has tracked since 2003. Notice how the most volatile classes (REIT's, Emerging Markets, Small Cap) rise and drop wildly year by year while more steady Bond and U.S. Large Cap classes shift more modestly.

Regularly predicting what will come out on top year to year has proven impossible, even for the experts. Fortunately, asset allocation only requires that we take some of the winnings—as often as possible—over the long-term. And that is a strategy anyone can follow.

The image below shows AAII's three standard asset allocation models (note the impact of the 2008 crash on the 10-year returns at the bottom!). Click here for more details and recommendations from AAII.

AAII Asset Allocation Models | AAII: The American Association of Individual Investors
AAII Asset Allocation Models | AAII: The American Association of Individual Investors