As complicated as investing may sound, there are only a handful of rules that you must follow to achieve your wildest financial dreams. Make sure to continually contribute to your account, select a wide array of diversified assets, only take on risk that is appropriate for you and don’t panic when the market gets turbulent. Besides these rules and a few others, it is mostly a waiting game.
But there is one aspect of successful long-term investing that often goes overlooked, something that will help protect your hard-earned profits through the market’s inevitable ups and downs. I’m talking, of course, about portfolio rebalancing.
Portfolio rebalancing is the act of periodically buying or selling assets in a portfolio to maintain an originally desired level of asset allocation (i.e. risk).
For example, let’s say that you have decided that the appropriate asset allocation for your portfolio is 60% stocks and 40% bonds. In most cases, you would have several other assets to consider but, for simplicity’s sake, let’s only focus on stocks and bonds. Because stocks are higher risk than bonds, the growth of the stocks in your portfolio will generally outpace the growth of your bonds. With this disparity of growth, it won’t be long before stocks make up a greater portion of your portfolio than 60%. The greater portion of stocks you have, the higher risk you are exposed to. So, if you want to limit this risk, you will sell stocks and buy bonds to get back to your original 60/40 allocation.
Let’s put some hypothetical numbers to this example to make it clearer.
In the above table, the first column shows our original portfolio mix. Just as we discussed, we have 60% ($60,000) in stocks and 40% ($40,000) in bonds. After one year, let’s say the stock portion of our portfolio had an excellent year and gained 20% ($12,000). The bond portion of our portfolio did well too, but only gained 5% ($2,000) on the year. As you can see in the second column, because stock growth outpaced the growth of bonds, we now have 63% ($72,000) of our total portfolio in stocks and 37% ($42,000) in bonds. This means that the overall risk of our portfolio has grown larger. Therefore, we must sell stocks and buy bonds to get back to our original allocation, as we have done in the third column.
Over time, if we keep rebalancing our portfolio, we should stabilize our risk. You can see what that would look like from the left side of the image above. If we were to never rebalance, our risk would continue to grow over time, as you can see from the right side of the image above. As you get older, you may want to lower your risk by lowering the stock portion of your portfolio. in which case, you’d sell a larger portion of stocks to buy a larger portion of bonds (e.g. a portfolio with 40% stocks and 60% bonds). So, the red (stock) area would decrease but still stabilize.
The principle of portfolio redistribution can be counter intuitive for some. You may ask: “If stocks are doing well, why should I sell them to buy bonds?” The more you are tempted to increase your risk with stock investing, the more you should err on the side of caution.
Consider the chart above for proof that you should not be tempted to pile into stocks, even when they are doing exceedingly well. Before the last two stock market crashes of 2000 and 2008, people were piling into the stock (equity) market while selling bonds and cash (MM). This is the opposite of what they should have done. Most investors were exposed to monumental risks at exactly the wrong moment. But now that you know the benefits of portfolio rebalancing, you can outsmart the crowd by stabilizing your portfolio risk.
Rebalancing your portfolio is not something you have to think too much about. Most IRA accounts, retail platforms (E*TRADE, Scottrade, etc.), robo advisors and 401(k) accounts have an option for automatic portfolio rebalancing. This allows you to tell an algorithm how you want your portfolio to be allocated and how often you want it to be rebalanced back to your original allocation. The most common rebalancing period is once per year. But you can rebalance every month, six months, two years and so on. It is all up to you.
Making investing as simple as possible is the best way to achieve your long-term financial goals. Don’t try to time markets. Not even professionals can time markets efficiently over long periods of time. Make your investment experience a breeze by implementing automatic portfolio rebalancing today.