What is portfolio rebalancing?Imagine you’re a 25-year-old whose target portfolio is 90% stocks and 10% bonds.
- Stocks and mutual funds (“equities”). When you own a company’s stock, you own part of that company. These are generally considered to be “riskier” because they can grow or shrink quickly. You can diversify that risk by owning mutual funds, which are essentially baskets of stocks.
- Bonds. These are like IOUs that you get from banks. You’re lending them money in exchange for interest over a fixed amount of time. These are generally considered “safer” because they have a fixed (if modest) rate of return.
- Cash. This includes liquid money and the money that you have in your checking and savings accounts.
- Manually — through buying and selling
- Automatically — through lifecycle funds
Manual portfolio rebalancingManually rebalancing your portfolio might appeal to you if you want a more hands-on approach to your investment strategy. Maybe long-term investing is a little too boring for you? Maybe you want to occasionally change up your asset mix? Whatever the case, you’re going to have to take three steps in order to rebalance your portfolio:
- Step 1: Find your target asset allocation. Hopefully, you set out a target percentage for each of your asset classes when you began investing. If not, that’s okay! Check out my article on asset allocation to help find one that works for you.In the example above, your asset allocation target was 10% bonds and 90% stocks. This is what you want your portfolio to look like once you rebalance it.
- Step 2: Compare your portfolio to your asset allocation target. How has your portfolio changed since you last saw it? Which investments got bigger and which need “pruning”?In the example above, your portfolio changed to 20% bonds and 80% stocks over time. You’re going to want to rebalance your portfolio now to reflect your target asset allocation.
- Step 3: Buy and/or sell shares in order to get your target asset allocation. To get your original asset allocation back in the above example, you’re going to need to either invest more into stocks OR sell your shares in bonds in order to go back to your original 80/20 split.Once it’s reverted back to your target asset allocation, congratulations! You’ve successfully rebalanced your portfolio!
- People want more $$$. It’s psychologically difficult to take money out of one asset class that is performing really well and put it in one that isn’t performing nearly as well.
- People procrastinate. Rebalancing portfolios isn’t exactly on top of everyone’s list of things they really want to do. It’s like cleaning your gutters: Something you know you “should” do but never really get around to. So we put it off or just forget to do it altogether.
Automatic portfolio rebalancing with target date fundsI wrote about this in my article on strategic asset allocation, but it’s worth mentioning again: Target date funds (or lifecycle funds) are great funds for people who don’t want to worry about rebalancing their portfolio every year. They work by diversifying your investments for you based on your age. And, as you get older, target date funds automatically adjust your asset allocation for you. Let’s look at an example: If you plan to retire in about 30 years, a good target date fund for you might be the Vanguard Target Retirement 2050 Fund (VFIFX). The 2050 represents the year in which you’ll likely retire. Since 2050 is still a ways away, this fund will contain more risky investment such as stocks. However, as it gets closer and closer to 2050 the fund will automatically adjust to contain safer investments such as bonds because you’re getting closer to retirement age. These funds aren’t for everyone though. You might have a different level of risk or different goals. However, they are designed for people who don’t want to mess around with rebalancing their portfolio at all. For you, the ease of use that comes with lifecycle funds might outweigh the loss of returns. One thing you should note: Most lifecycle funds need between $1,000 to $3,000 to buy into them. If you don’t have that kind of money, don’t worry. I have something for you at the end of this article that can help you get there. To recap: 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. For a more in-depth explanation, check out my video all about lifecycle funds.
Master your personal financesAsset allocation isn’t hard. What IS hard is getting started — which is why I’m happy you’re here. If you’re interested in tactical asset allocation, chances are you already have a good idea of how you want to approach your investments. However, if you want to earn MORE money so you can invest even more, I have something for you:
- Create multiple income streams so you always have a consistent source of revenue.
- Start your own business and escape the 9-to-5 for good.
- Increase your income by thousands of dollars a year through side hustles like freelancing.
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