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Welcome to Get Smart about Investing. Asset allocation was step one: Make sure you maintain a balance between aggressive and conservative investments. Diversification is step two: Make sure that within each of these areas, you’re exposed to many different assets so no area can dictate your entire investment return. Again, participate in areas that are doing well and limit yourself in areas that are not. Step number three is portfolio rebalancing. Rebalancing is simply adjusting your investments to get back to the plan that you were following.
Over time, all of your investments will vary in performance and some investments will do better than others. What if you started the year with 80 percent of your money invested in stocks and 20 percent invested conservatively because you were following an 80/20 plan? If the stock market did very well over the next few years, it’s very possible that 95 percent of your portfolio’s value would be invested in stocks and just 5 percent of it in bonds, because the stocks grew faster than the bonds. Your portfolio is now overly exposed to stocks, with 95 percent of it invested in the stock market. The right plan for you to follow should have been an 80/20 plan. Rebalancing your portfolio would involve selling a small portion of your stocks and buying bonds to get back to the plan you were following.
By not rebalancing, you would actually be taking on too much risk. You’d be in a plan that’s more aggressive than the one you’re supposed to be in. The same concept would apply to each of the subcategories of different investment types we’re looking at. If the healthcare industry does really well, you’ll probably end up overinvesting in healthcare and would need to move into other areas so you’re not overexposed to any one risk. If small companies were performing poorly, perhaps too much of your stock portfolio would end up in large companies; and thus your diversification would be reduced; again, increasing your risk.
Why is rebalancing so important? The answer is it forces you to do three things that most investors don’t do:
1. Follow and stick to a consistent investment plan each year, tailored to your particular situation.
2. Keep emotions out of investments. Following a plan helps you make investment decisions based not on your emotions, but on a logical framework consistent with what your portfolio needs.
3. Rebalance investments. This forces you to buy investments that have gone down in value and sell investments that are going up. It’s the opposite of how most people think about investing. Think about it. If an investment did great, no one would want to sell it. Very few investors will ever take money off the table when they’re doing well. Look at the late 90’s as an example. Investors were receiving 50 to 100 percent returns and it was not enough for them.
If you were rebalancing your portfolio, you would have shifted some money from technology stocks to bonds and more conservative areas before the market conditions changed. On the other hand, no one wants to buy an investment when the market is doing terribly, although that’s the best time to invest. 2002 and 2003 would have been the best time to buy stocks, but very few people did. By rebalancing, you’re forcing yourself to make investment decisions that very few people can make on their own. Creating a successful plan is all about removing your emotions and gut feelings from the investment situation.
I’m Greg McGraime and Now You Know!