Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. In theory, the returns of the three major asset categories do not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns.
By investing in more than one asset category, you’ll reduce the risk that you’ll lose money and your portfolio’s overall investment returns will have a smoother ride. For example; a conservative investor would use 50% of their funds to purchase stocks, 40% to purchase bonds and 10% in cash. While a more aggressive investor might have 75% in stocks, 20% in bonds and 5% in cash.
Re-balancing Your Asset Allocation
Re-balancing is bringing your portfolio back to your original asset allocation mix. This may be necessary if over time some of your investments may become out of alignment with your investment goals. You’ll may find that some of your investments will grow faster than others.
For example, let’s say you determined that stock investments should represent 50% of your portfolio. But after a recent stock market increase, stock investments represent 70% of your portfolio. You’ll need to sell some of your stock investments and purchase some bonds to reestablish your original asset allocation mix. By re-balancing, you’ll ensure that your portfolio does not overemphasize one or more asset categories, and you’ll return your portfolio to a comfortable level of risk.
When to Consider Re-balancing
You can re-balance your portfolio based either on the calendar or on your investments percentages. Many financial experts recommend that investors re-balance their portfolios on a regular time interval, such as every six or twelve months. Others recommend re-balancing only when an asset class increases or decreases more than a certain percentage that you’ve identified in advance.
Weaknesses of Asset Allocation
- Selling your winners to buy more losers not always a good strategy, no guarantee that your losers will become winners
- Re-balancing too often will increase transaction costs reducing the value of your portfolio
- Asset allocation alone will not protect your portfolio from raising interest rates or inflation which will affect the value of most asset categories.
- Offers little protection during a major economic crisis like 2008-09 when both stocks and bonds went down in value.
Keep in mind that asset allocation will not protect you from losses in the future if you panic and sell too soon just because markets went down in value. Markets do bounce back; sometimes you just have to wait it out.
Next week’s lesson: Diversification