Recall in the article, Investment Tips we can Learn from Pablo Escobar, we talked about the importance of diversification in your long-term approach to investing. In order to spread out your risk and maximize your returns, you break up your portfolio into different asset classes. In today’s article, I’m going to be discussing another important long-term approach called rebalancing.
As an investor, you are going to select a certain asset allocation that aligns with your goals and risk tolerance. Let’s take a look at an example of one below.
Bob took a great deal of time to put this asset allocation together. Now he is ready to put it on autopilot and let his investments start to make him money while he sleeps! What Bob doesn’t realize is that his asset allocation can greatly change as time goes by. Sometimes this can be years, other times it can be as short as a couple of months. Let’s look at Bob’s asset allocation after two years. Remember, keep in mind that he hasn’t touched it during this time.
Whoa! So as you can see, Bob’s percentage in stocks jumped by almost 20%! My guess is that this is way more risk than he would like to take on at this point. How does this happen? Remember some asset classes will overperform in certain economic conditions and others will underperform. Looking at these charts we can see that in the past two years, stocks have overperformed and bonds have underperformed causing Bob’s portfolio to shift. Even though this might have been a lucrative shift for Bob, it has taken him out of his target asset allocation. Bob is now taking on more risk than he is comfortable with and it could greatly hurt his portfolio in the future. You can think of this like playing jenga. Over the long-term your portfolio starts to become more and more unbalanced till it is one the verge of collapse. This is where rebalancing comes into play.
Rebalancing is simply looking at your portfolio once or twice a year to make sure your asset allocation is still in line with your goals. Think about if Bob’s portfolio is now 71% in stocks and the market goes into a recession like 2008. Bob could see a significant part of his portfolio drop!
I like to think of rebalancing like the typical fitness minded athlete. There is always a constant struggle between being more muscular and being leaner. The more you want to put on muscle you begin to do less cardio and eat more. On the other end, when you want to be leaner, you start to do more cardio and eat less. Let’s take a look at Dom’s current fitness asset allocation. Dom’s goal right now is to slowly put on muscle while staying lean.
Dom starts to get complacent with slowly building muscle while staying lean. He wants to get stronger quicker! Slowly over time, his fitness asset allocation begins to change.
So much for the lean bulk! Now Dom has put on way more body fat than he would like and the steroids are giving him some serious backnee. Dom has gotten away from his goals. He needs to rebalance his fitness portfolio if he wants to get back on track!
Putting your account on autopilot does not mean that you can neglect it completely. If we want to maximize our returns and meet our financial goals, we need to make sure our asset allocation stays on track. I don’t think looking at your portfolio twice a year is too much to ask!
Homework: If you have a self-directed account now, think back to when you looked into how it is allocated. Make a note on your calendar to set some time aside twice a year to go over your long-term approach.