The reasons for investment success are not obvious. Most people mistakenly believe that your stock choices determine your success. In reality, you shouldn’t even be picking individual stocks. Others believe that timing the market works, which is false.
In reality, one of the most important parts of investing — perhaps THE most important part, besides starting early — is your asset allocation. This is basically the way you’ve laid out the pie chart of your portfolio: How much do you have in equities (stocks)? How much in bonds? And how does it change over time?
However, several investors are a bit confused about the whole thing. Many questions abound: what is asset allocation? How does one fix the allocation? And so on.
These questions have brought back the ancient 100 minus age formula back in circulation. As per the equation, an investor can subtract his age from 100 to find out his ideal equity allocation. For example, a 30-year-old investor should invest 70 per cent in equity and 30 per cent in debt. Though many advisors use it even today to convey the concept of asset allocation to investors, the approach is not considered ideal for every investor.
Asset Allocation vs Rebalancing Portfolio: What is rebalancing?
Rebalancing is bringing your portfolio back to your original asset allocation mix. This is necessary because over time some of your investments may become out of alignment with your investment goals. You’ll find that some of your investments will grow faster than others. By rebalancing, 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.
For example, let’s say you determined that stock investments should represent 60% of your portfolio. But after a recent stock market increase, stock investments represent 80% of your portfolio. You’ll need to either sell some of your stock investments or purchase investments from an under-weighted asset category in order to reestablish your original asset allocation mix.
Over time, your asset allocation will change, and so will your needs. At 45, you’ll want to become more conservative and protect what you’ve acquired. You can’t afford the same risk as a 25-year old. At 65, you are simply waiting for your inevitable death, so you become correspondingly more conservative.
Asset Allocation vs Rebalancing Portfolio: Changing Your Asset Allocation
The most common reason for changing your asset allocation is a change in your time horizon. In other words, as you get closer to your investment goal, you’ll likely need to change your asset allocation. For example, most people investing for retirement hold less stock and more bonds and cash equivalents as they get closer to retirement age. You may also need to change your asset allocation if there is a change in your risk tolerance, financial situation, or the financial goal itself.
But savvy investors typically do not change their asset allocation based on the relative performance of asset categories – for example, increasing the proportion of stocks in one’s portfolio when the stock market is hot. Instead, that’s when they “rebalance” their portfolios.
Asset Allocation vs Rebalancing Portfolio: Why Asset Allocation Is So Important?
By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset categories have 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. If one asset category’s investment return falls, you’ll be in a position to counteract your losses in that asset category with better investment returns in another asset category.
Asset Allocation vs Rebalancing Portfolio: When to Consider Rebalancing Portfolio?
You can rebalance your portfolio based either on the calendar or on your investments. Many financial experts recommend that investors rebalance their portfolios on a regular time interval, such as every six or twelve months. The advantage of this method is that the calendar is a reminder of when you should consider rebalancing portfolio.
Others recommend rebalancing portfolio only when the relative weight of an asset class increases or decreases more than a certain percentage that you’ve identified in advance. The advantage of this method is that your investments tell you when to rebalance. In either case, rebalancing tends to work best when done on a relatively infrequent basis.