Oh, I know he’s beloved by millions. And I can’t wait to bite off those chocolate bunny ears he will bring me on Sunday. But let’s face it, you wouldn’t want to get your financial advice from someone who puts all his eggs in one basket! You have probably heard that old adage, but do you know what it means?
Portfolio Diversification
Have you ever been in rush hour traffic and the lane you are in is practically stopped, but the other lanes around you are moving faster? So you decide to switch lanes, but as soon as you change lanes, your new lane slows down, and the lane you were in finally speeds up. That’s the problem with only being able to make one choice at a time: you have to pick the right one, or you lose. With investments, it is even trickier because there are so many different areas in which to invest. Luckily, with investments, you do not have to choose just one. You can diversify and put a little bit of money in each area so that you are sure to be invested in the best-performing area, but you do not have all of your money invested in the worst-performing area either.
Asset Classes
So what are these areas of investing that we are talking about? A portfolio should be diversified, or spread out, among stocks, bonds, and cash. Whether you should invest in an asset class or how much depends on your particular situation.
Depending on your situation, your stock portion can be divided among the following asset classes:
- Large Company, United States stocks
- Mid-Sized Company, United States stocks
- Small-sized company, United States stocks
- Developed International stocks
- Emerging Markets stocks
Depending on your situation, your bond portion can be divided among the following asset classes:
- Short-Term Bonds
- Intermediate Term Bonds
- Long-Term Bonds
Portfolio Rebalancing
You have probably seen the investment pie charts, either in your work retirement plan materials or, if you have an investment account, in the materials they provided you. Have you ever wondered, “Why is it that everyone keeps telling me to use these darn pie charts?” Each different color of the pie chart represents a different asset class, and that illustrates the diversification of the portfolio. So, once you pick your asset classes and populate them with investments, are you done right? Not so fast!
Annual Portfolio Rebalancing: The most important part!
The marketing materials give you the pie charts; they just don’t tell you how to use them. And that is a shame because, when used properly, in a disciplined fashion, they can take a lot of the stress out of market downturns. Here’s how.
Picture your pie chart, let’s say that your pie chart tells you that you should have 35% in Large Company United States stocks, and that area of the market has had a terrific year, and you have watched that portion grow from 35% to 38% to 40% to 45% in a year’s time! “Wow”, you say, “I have finally found an investment that makes money!” So human nature tells us, “Add more money to it”. But not so fast. Haven’t we all heard that to make money, we are supposed to “Sell High and Buy Low”? Well, fortunately for us, the pie chart is going to help us do that. More on that in a minute.
Picture your pie chart again, let’s say that your pie chart tells you that you should have 15% in Small Company United States stocks, and the market has not been kind to small companies this year. You watched your Small Company slice of pie shrink from 15% to 12% to 10%. Your first instinct might be to sell this investment because it didn’t do as well as the others. But that is not what you should do; instead, you should “Buy Low”. Without a plan, human nature makes us do the wrong thing at the wrong time.
Now, that does not mean you buy a poor quality investment, speaking to the topic of diversification again, when you buy a single stock, it can go out of business. When you buy an investment that represents an entire asset class, such as an S&P 500 index fund, it is highly unlikely that all 500 companies will disappear at once.
Annual rebalancing is simply the discipline to evaluate the portfolio once a year to look for changes in the quality of any of the investments and then to check to see if your asset allocation (slices of pie) have gotten out of alignment over the year. If they are more than a few percent off, make some changes. Please keep in mind that there may be tax consequences unless you can make the adjustments in retirement accounts.
What Annual Rebalancing will do for you:
1) Help you sell high (the best performing asset classes) so you can take your money off the table.
2) Help you sell high so you can protect yourself if when “the bubble bursts”. Have you ever noticed that it is often the investments that have gained the most that end up falling the most when the market corrects?
3) Help you buy low (the underperforming asset classes), when prices are low.
4) Helps you prepare for when the underperformer rebounds.
2008 worst performing asset class was MSCI Emerging Markets -53.18%
2009 best performing asset class was MSCI Emerging Markets +79.02%
5) Removes emotion! Emotion has you selling when you should buy and buying when you should sell. But having a diversified portfolio and using a pie chart with an annual rebalancing plan will get you through every type of market cycle.
Michele Clark
Michele has more than 25 years experience in financial services and has developed a specialization in working with people who are starting to seriously think about their retirement or who are retired and facing all of the complex planning issues one faces during this time.
She works with clients to coordinate decisions around investments, retirement accounts, Social Security, funding health care, tax planning, cash-flow, maximizing employer benefits, charitable gifting strategies and estate planning.
Before joining Acropolis Investment Management, Michele was the founder and managing principal of Clark Hourly Financial Planning and Investment Management for nearly nine years with an additional sixteen years at banks and investment firms.
Michele has been quoted in such online and print media outlets as The Wall Street Journal, Money Magazine, USA Today, Market Watch, US News & World Report, CNBC.com, AARP, St. Louis Post Dispatch, Fox Business, Forbes, Los Angeles Times, Financial Planning Magazine, St. Louis Public Radio, Yahoo Finance, St. Louis Magazine, and others.
Michele earned her B.A. from Purdue University. She is a CERTIFIED FINANCIAL PLANNER® practitioner, obtained the Chartered Retirement Planning Counselor (CRPC®) designation from the College for Financial Planning, and is a NAPFA Registered Investment Advisor.
Michele has volunteered her time for financial literacy outreach at Financial Planning Days, Money Smart Week, Habitat for Humanity and others.
Michele has served on the Board of Directors of the Financial Planning Association of Greater St. Louis since January 2014 and is Past President and currently serving as Chair of the Board.