Rebalancing & asset allocation: critical for investing. So why don’t you do it?

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As you know, I love mocking people who believe that we are “rational” and “logical.” These tend to be economists, engineers, and other people who are clueless about human behavior.

One of the best ways to reveal the difference between what rational people “should” do and what real people actually do is to talk about rebalancing and asset allocation.

Today, I want to demystify what most people think determines investor success…versus what actually matters.

 

* * *

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 (though this is what men in their 40s talk about at parties…that and traffic routes). 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?

 

Are you in your mid-20s? Here’s a sample asset allocation for you

Look at that chart. Again, most people mistakenly believe that “investing=picking stocks” and therefore they need to worry about which stocks to buy, when in reality the actual equities (stocks) you choose are far less important than your overall asset allocation. In other word, your pie chart matters more than the actual ingredients.

Ok, so the person in the above example is 25. Under which conditions would the pie chart change?

It turns out this is one of the most important questions investors can ask themselves.

What is rebalancing?

Over time, your asset allocation will change, and so will your needs. For example, let’s say the stock market climbs for a 10-year period. You may have far more stocks than your pie chart calls for, so you’ll want to adjust back down.

Alternatively, your needs will also change: When you’re 25, you have a long time before you need your long-term investment money. Therefore, you’re risk-seeking: You have a large appetite for risk because you want higher potential rewards.

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.

I wrote about this more eloquently in my book, so here’s an excerpt. And yes, I find it remarkably fulfilling to quote myself:

 

 

How do you do that?

Who wants to monitor that?

Asset allocation and rebalancing are hard

Asset allocation is complicated. The best institutional investors in the world — like investment managers at university endowments — are hyper-focused on deciding whether they should have 13.1% or 13.3% of timber, or venture capital, or hedge funds, in their portfolios.

But asset allocation is complicated for individual investors, too — though not for the reasons you think. Since individual investors don’t have access to sophisticated alternative investments, we essentially have to decide among 3 areas of investment: Equities (stocks), fixed-income (bonds), and cash. 3 choices. On the surface, it doesn’t seem too difficult.

But over time, it becomes profoundly difficult to maintain the “right” asset allocation. Why? The reason may surprise you.

The Looming Enemy: Why you don’t rebalance

We now know that asset allocation is one of the most important factors in investing success. So why do we find it so difficult to maintain a reasonable asset allocation? Why do you find grandmas with 90% in stocks, while you also find 25-year-olds with 30% in bonds?

Since we’re wading into fairly advanced investing strategy, you might think that the primary reason is that people don’t know about complex mathematical models or fail to understand some deep nuances of investing.

Not so.

The primary reason we fail to maintain a reasonable asset allocation is human psychology. We are subject to many powerful psychological biases when it comes to investing (more about the psychology of money).

Even if we have a helpful chart like this…

…we still fail to maintain a reasonable asset allocation over time.

“This analysis assumes that for all of these portfolios, investors kept their money in the funds through the hair-raising markets of 2001 and 2002 and rebalanced the portfolios annually, returning them to their original allocation. But such disciplined rebalancing can be a tough sell, said Hersh M. Shefrin, a professor of behavioral finance at Santa Clara University in California. “We are pleasure-seeking beings who want to avoid pain,” Professor Shefrin said.

Rebalancing, he said, would have forced investors to do exactly the opposite — by making them either prune assets that had done extremely well, or to load up on assets that had disappointed them.” (via NYT)

To put a finer point on it, from a nice article in the Canadian Business Online blog:

“When stocks were crashing in late 2008 and early 2009, did you rebalance your investments? Did you actually move money out of cash and bonds into stocks?

Many did not. They either froze or dumped stocks in a panic. At least that is the conclusion of a recent study released by two finance professors, Louis H. Ederington and Evgenia V. Golubeva, at the University of Oklahoma.”

Let’s get to the nitty-gritty of what you need to know.

What you need to know about asset allocation and rebalancing

  • Asset allocation is the #1 or #2 most important thing you can control when it comes to investing
  • Contrary to what most people think (especially technical people), the difficulty in maintaining asset allocation is not technical skill. It is investor psychology. You will inevitably think you can out-think the market. You will fall prey to several investor biases. You will not be disciplined enough to rebalance on a regular basis. You are human. “Trying harder” in this area doesn’t work for 99% of people.
  • Forget picking stocks, since investing is not about picking stocks. Again, investing is not about picking stocks. Most individual investors shouldn’t even pick one stock. Instead, they should use target-date funds (aka lifecycle funds), which choose an asset allocation based on your age and automatically rebalance for you over time.
  • The media does not like to write about asset allocation because it’s complicated, scary, and you can’t easily put a picture of a guy standing in a suit with his arms crossed talking about how asset allocation helped him pay off his debt and send his kids to college. Jesus christ I am getting angry writing this
  • Most people don’t even know what asset allocation is. But even those who do fail to rebalance their portfolios in a disciplined way. This is true even of professional portfolio managers!
  • The best solution is to automate this process by investing in a target-date fund (aka lifecycle fund). Those funds automatically rebalance for you. And for each person who debates minutiae about the minor percentages they disagree with (“it should be 16% large-cap, not 14%!!!”), 1000x more people are helped by the automation of regular rebalancing.

Investing without an asset-allocation plan is like riding a tricycle in South Central LA, naked, blindfolded, wearing a large fanny pack full of $20 bills. It doesn’t matter how disciplined you “think” you are going to be in steering straight and true. You are still going to get your ass beat.

Most investors don’t even have a plan for their asset allocation. They simply invest randomly here or there, picking a fund or stock that catches their fancy. 40 years later, they complain about the government, taxes, and the media for their poor investing returns. (They’re not the only ones to blame, of course.)

But perhaps even more pernicious are the people who are well-read about investing — but then decide they want more “control” so they’ll manually adjust their asset allocation. This may work when they initially start investing and are highly motivated, but over time, they — like everyone else — fall prey to natural human biases and weaknesses, leaving them with an exposed asset allocation. Perhaps 1% of investors can maintain the discipline to maintain an appropriate allocation over time.

Chances are, you can’t.

I know I can’t. And that is why I use target-date funds.

Bottom line: You are human. No matter how motivated you are about investing right now, you will find other things more urgent and important later. We are all cognitive misers with limited cognition and willpower. Investing in a target-date fund lets you compensate for your natural weaknesses and biases by automating complex asset-allocation decisions.

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If you liked today’s post, there’s plenty more where that came from. I’d love for you to join my private list, where I share exclusive content on:

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48 Comments

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  1. “Since individual investors don’t have access to sophisticated alternative investments, we essentially have to decide among 3 areas of investment: Equities (stocks), fixed-income (bonds), and cash.”

    Since…
    1. The point of asset allocation is to avoid holding correlative assets (diversification)
    and…
    2. In market downturns correlations between equities and fixed income securities strongly increase
    and…
    3. Cash holdings are almost guaranteed to lose purchasing power over time

    …it seems that commodities, especially precious metals, should be a consideration for the average investor also.

  2. Great reminder, Ramit. Glad to say I got my lifecycle fund completely automated and ready to go this past month. A very good feeling to know that my money will be growing and reblancing itself over time and I don’t need to worry about a thing.

    Also, what are your thoughts on 401k contribution increases (usually 1% per year), most famously talked about in “Nudge,” and available in most retirement funds these days? Haven’t heard you really speak to this option.

    Finally, best line of this post, “Investing without an asset-allocation plan is like riding a tricycle in South Central LA, naked, blindfolded, wearing a large fanny pack full of $20 bills. It doesn’t matter how disciplined you “think” you are going to be in steering straight and true. You are still going to get your ass beat.”

    Very good, very good!

  3. Asset allocation is probably the second most important thing to do with your investment portfolio after asset selection. Unfortunately, it is also the last thing that most people focus on.

  4. Ramit,

    I agree with you on the psychology of investing, but I think some caution should be provided for the use of target date funds. William Bernstein’s Four Pillars of Investing offers very sound reasoning for limiting equity investments to 80% of total portfolio. Jack Bogle (Vanguard founder) recommends your age in bonds.

    So the 25 year old investor should consider 75% to 80% equities. If you’re a higher income earner your need to take risk is further diminished. You may not be able to tolerate losses based on a 90% equity portfolio. So instead of using the 2050 target date fund you may want to invest in the 2030 or 2020 target date fund in order to get the asset allocation you want/need. There are also tax consequences when using target date funds in taxable accounts.

    Good article. It reminds me that I need to plan my reblance ;)

  5. Asset Allocation is paramount. However, not all of us are living in countries who offer a variety of investment tools, like lifecycle funds. In my country, there are non such machenism.

    To maintain asset allocation, I’ve decided that every quarter, on pre-defined dates (1/1,1/4,1/7,1/10) I will rebalance my asset allocation, and every 2 years I will re-consider if my asset allocation still matches my needs.

    Any ideas on different methods to rebalance without automation? I’ve heard people argue that once an asset class changes for more than 5%, it’s a good time to rebalance, what are you thoughts on this way of thinking?

  6. I would argue that how much money you put into your investments is even more important that asset allocation and about as important as starting young, but I don’t want to quibble. Man, I felt the pain during the Great Recession. I stayed the course but I am also my mother’s informal (unpaid) advisor and we fired her financial planner, whose only real service was asset allocation but wasn’t doing it, and took it upon ourselves to re-balance a portfolio that was way over-invested in real estate. Also, you should do a rant on the scheming fraudsters who took advantage of people’s fears during the recession to sell them annuities and life insurance. That was the first thing every new financial advisor that we interviewed suggested and that’s why we ended up doing it ourselves.

  7. Ramit
    Thanks for the link. I think many beginning investors don’t prepare themselves mentally enough for the ups and downs (or their advisor doesn’t). W. Bernstein actually suggests, contrary to conventional wisdom, beginners should start out with small allocations to stock. After they’ve been through a cycle or two, then they can move to the “100-age” rule for stock allocations.

  8. How are you able to manage risk with target-date funds? The market resembles a casino on a day-to-day basis, but is supposed to even out over a 30-40 year period. Should risk adverse people be discouraged to invest in target-date funds because of the volatility of the market? When I check my Vanguard account, I find it disheartening when I notice that I lost $500 of my savings in May alone.

    • Brent, that is such a great question. As long as you have your investments automated (using target-date funds), I check on my investments every 6-12 months. That’s it. There is no reason to log into your investment account on a day-to-day basis. Doing so will drive you nuts.

      Instead, focus on more important things like earning more money or even just hanging out with friends/family.

  9. Ramit,
    Do you use target-date funds in your taxable (non-ira/401k) accounts? Should I be concerned about taxes from the fixed income portion of these funds? I’m in the highest marginal tax bracket, so I usually by tax-free muni bond funds for my fixed income investments.

  10. The only reason I don’t use target date funds in my 401k is because the fees are higher – at least 1%, maybe 2%. So I attempt to create my own. But you are right, I need to keep up on the rebalancing.

  11. I disagree with many of the things you said here Ramit but this one I completely agree with “There is no reason to log into your investment account on a day-to-day basis. Doing so will drive you nuts.” That’s probably the single most important piece of advice you can give to any prospective investor. Checking your account every day will drive you either crazy or to make bad decisions. Pick a strategy and stay with it for a while because in the short run the market is essentially random.

  12. “At 65, you are simply waiting for your inevitable death”

    LOL, something to look forward to?

  13. Ramit,
    I agree most investors should utilize some form of established portfolio because it seems in general, much of the public has a poor understanding risk and how much they can actually tolerate let along asset allocation.

    Bear markets do funny things to otherwise logical people and the classic example is when people in their 20s and 30s say things like, “I don’t want to invest in stocks through my 401k until the market improves.”

    I’d argue that any young person that’s been a net buyer in the stock market over the last decade should consider themselves one lucky SOB.

  14. Great stuff Ramit. Totally agree that the media has totally distorted the definition of investing, causing lots of folks to lose track of things like asset allocation. I also agree with the commenter above who noted that putting money into your investment accounts is more important that allocation. Finally, I’d like to point out that there are at least two additional options beyond “stocks” and “bonds” for individual asset allocators (and not just further divisions thereof, like “small cap” vs “large cap”). Those two are real estate and commodities. Both have something of a bad rap, but in terms of seeking out non-correlated assets (the true purpose of diversity), each can add something to a well-managed portfolio.

  15. I’ve been on Ramit’s life cycle fund plan for over a year now and am very happy with it. I will say, though, it takes some discipline.

    I regularly have conversations with people telling me how much they made buying the right stock at the right time. I know they won’t be sharing with me how much they may have lost in another investment, but it’s tough not to get a little caught up in it.

  16. I dont know that I agree that you shouldn’t watch stocks more closely than every 6-12 months. Back in 2001, I had an investment account set up for my oldest son’s university education. I wasn’t paying attention to it (was out of the country working at the time) – and ended up losing 80% of it. I like to think I would have stopped the bleeding earlier, although chances are I may not have anyway and likely would have hoped tech would rebound as many did.

    I do think that if you know an industry really well, one of the best things you can do is invest in that industry. I got heavily into O&G at the bottom of the market 18 or so months ago and am EXTREMELY glad that I did. But overall, I’m only 20% into stocks and 80% in mutuals funds with an energy / financial services emphasis. I’m taking on quite a bit of risk for a “retired” 44 y.o. but I’m a high earner and prepared to go back to work for a couple of months if the market tanks.

  17. Target date funds are definitely the way to go. I recently went to the effort of comparing my 401K YTD performance of my funds versus a single Target Date fund that would match my retirement date. I did this by assuming I cashed out of my current funds on 12/31/2009 and reinvested 100% in the Target fund. Then I looked up the historical prices of the target date fund on the dates my payroll deductions were invested into my current funds this year. The difference in my actual account balance versus what it would have been worth had I actually cashed out and invested in a target date fund was minuscule. BUT what would have been saved was all the stress and time spent worrying about whether I was in the right mix of funds.

  18. Another option for many 401k and IRA plans through Vanguard, Fidelity, T Rowe Price, etc., is to set up an automatic rebalancing of your separate mutual funds. I have mine set up to rebalance every 6 months to the target allocation, but once a year should probably to the trick. That’s a good automated way to do it and still have control over the individual fund choices that a TDF doesn’t offer you.

  19. I’m 44 and my 401K is 100% invested in equities because every single time I have put money into bonds, I have lost money, so I’ve given up on them. I just don’t understand how to make that recommendation work. My 401K plan offers Fidelity and Vanguard bond funds, a variety of stock funds, and a money market fund. My risk tolerance is quite high, and my father who is 72 also has his entire portfolio in equities, but he also has a pension and social security so he’s not relying on his portfolio the way I will be. I have been divvying up my assets among the following types of funds available to me: US index, large cap, medium cap, small cap, emerging markets, european markets, and asian markets, but I don’t know what else to do. I’m rebalancing every 6 months. Any advice?

    • Read a book! You’re doing it wrong, Tara. It might have worked temporarily but it will not work over the long term. And please, please, please tell your Dad to read a good book on investing, too. Being 72 and being 100% in equities is almost never, ever the right decision. You can read mine or The Bogleheads’ Guide to Investing. But please spend a weekend getting educated.

  20. My dad’s happy with his portfolio – he’s withdrawn more money over the past 15 years than he ever put into it and it’s still over 800K – but I’ll have a look at a couple of those books. It’s going to take a lot of convincing for me to invest in bonds though given my past history with them. Would the 100-age formula work with a mix of equities and money market instead of equities and bonds?

    • No. You’re talking about a lot of money. It’s worth getting educated about this instead of using half-cooked formulas without a deeper theoretical understanding.

  21. Hi Ramit,
    I am so glad that you wrote about re-balancing your allocations once a year.

    What most people don’t realize is re-balancing your asset allocations automatically forces you to “sell high and buy low”. I can’t think of any other method that does this so effectively.

    I use to do this manually and it was very difficult because emotionally you don’t want to do it.

    Tim

  22. Ramit,

    Do you know of any software (preferably, free Excel plugins) that can help with portfolio allocations and re balancing?

    Thanks.

  23. All target date funds are not created equal. Some charge crazy high rates for transactions. Some have lost money since inception. Some have done fantastically well since inception. As will all things, do your research before buying.

  24. [...] Rebalancing & asset allocation: critical for investing. So why don’t you do it? » AKPC_IDS += "5736,"; [...]

  25. [...] «  Rebalancing & asset allocation: critical for investing. So why don’t you do it? [...]

  26. This is confusing as shit.

  27. Yet you refuse to acknowledge your suggested lifecycle funds have taken extreme hits in value. They have been counterproductive to successful investing.

    Are you even invested in what you push? Do you not realize they’ve underperformed significantly?

    You claim the market cannot be timed, yet business cycles are a known and predictable occurrence. Anyone who took 5 minutes to look at it would have avoided it and your lifecycle funds, preserving the value of their investments.

  28. Great article, Ramit.

    My personal strategy (somewhat influenced by John Bogle and the Bogleheads) is to follow the general rule of thumb that the % of bonds you should own should equal your age. Since I am 29, I try to own 29% bonds (a little less is OK). I don’t buy target date funds, but I load up on Vanguard and Fidelity index funds. I diversify these funds and rebalance the individual funds themselves as well as the bonds. Since I am right now constantly buying funds, rebalancing usually just means buying more bonds.

    I’m going to try to outline my personal strategy on my own personal finance blog, which I just got off the ground.

    It’s amazing how 95% of the people out there don’t know these simple principles.

  29. [...] Rebalancing & asset allocation: critical for investing. So why don’t you do it? » June 27th, 2010 | UMF | No Comments [...]

  30. Ramit,

    Thanks for posting. Reading through the comments, I’m definitely going to get your book and read it, I just put it on hold at the library. I wonder if this allocation applies to me.

    I just turned 26 and am all equities for retirement. (80% 401k S&P 500, 10% Roth IRA Vanguard Total Stock Market, 10% Roth IRA Vanguard Total International Index). I’m extremely risk tolerant, and have never considered selling over the past 4 years. I know the research shows that trying to time the market produces worse returns. Why should I have 10% of my retirement funds in Bonds? I’m thinking of moving the 401k all to Vanguard Total World Stock ETF.

    Craig

  31. On the whole, great post and many valid points made. Especially enjoyed the example of how rebalancing could have helped investors in the midst of 2008/2009 crash.

    Some grandmothers CAN afford to have a high exposure to equities, if they are very well off and looking to pass on wealth to the next generation (grandchildren, etc). That generation has a longer time span, and so it would be a shame to shortchange the gains they could experience over the long haul. Not every situation is black and white.

  32. Ramit,

    Any suggestions on asset allocation for mid-to long range investment objectives other than retirement, such as savings dedicated to buying a home or paying for your children’s college education? Do you recommend investing in equities for these purposes, and if so, how do you recommend transitioning your asset allocation over time as the date you will need to use the money approaches?

  33. Hi Ramit

    I absolutly agree with you on asset allocation. Many investors overlook this part and therefore fail. Thx for a great blog and the many good advises.

  34. The thing that makes me feel weird about the life cycle fund/target funds is that it’s one single fund. I know it’s invested in a lot of different other funds, bonds, stocks, etc. But it is still one fund. It doesn’t feel like I’m diversifying. Having a large percentage of my retirement portfolio invested in one fund seems very risky.

  35. Great article Ramit. The best thing I ever did was to set up automatic asset allocation!

  36. You’re right on about investor psychology. My tendency to think I can outsmart the market frightens me because I know that I know very little, and so many others know so much and have so much better information. Where does this idea come from that I can beat this system? Yet there it is. I think following your advice takes a healthy level of humility, and that’s not a bad thing.

  37. If you are in your 20′s and have come across a substantial amount of money would that pie chart still hold true??

    It would be nice to see a breakdown by age of when you should add more slices to the overall pie…

  38. I am yet to see a single post here that talks about common sense approach. When you work so hard for your money, why let others manage it for you. These suite n tie people always confuse you cause thats what they are to do.
    Stick to the basic and protect your own money.
    Moving forward its all going to hell so watch these equities, bonds, 401, 397y64 373 bs plans.
    Hold on to your cash and thats all there is to it…make ur decisions on future not past…yes there was inflation but we are looking at deflation…
    i just get annoyed by people who act like all this and write books and tell people how to get their life long savings thrown into a hole but selling books makes money so why not

  39. Asset Allocation is a very intimidating subject! Thanks for breaking it down here!

  40. Check out Marketriders.com – I’m a happy customer, not an employee. ETF-based, low-cost and pings you when you need to rebalance

  41. Economists know that people are not rational.
    It’s true that they use models where they assume people are rational, but the majority is aware of the flaw in this assumption.

  42. Thanks for the advise. Asset allocation can be pretty intimidating.

  43. yeah i have a target date fund ira but my company 401k I have to reallocate myself and it is an intimidating and terrible thing and I have been putting it off. I know I need to do it but I am not quite sure what or how to go about doing it.

    sigh.