Diversification, Allocation, and Rebalancing
Feeling some jitters about the roller-coaster stock market? This week’s Yahoo!Finance column discusses why, once you figure out an allocation strategy for your investments, the best move is to do nothing at all.
What follows is a how-to for novice investors who don’t understand how portfolio allocation works.
Allocation is a tool based on the old adage “don’t put your eggs in one basket.” When you’re contributing to a 401(k) or an Individual Retirement Account, your impulse may be to throw everything into a single mutual fund and be done with it forever.
But you need diversification—putting some of your investments in stocks and some in bonds—because this reduces the risk of losing money. The financial markets tend to move in cycles. Stocks may be up while bonds are down. Different types of stocks move in and out of favor as well: At one point, investors might be hot for small company stocks and their prices go up, while demand wanes for large-cap stocks, and they decline in price. Then it reverses. Or, foreign stocks become the rage.
The goal is to maintain a mix of stocks and bonds, so your portfolio is like a fleet of aircraft carriers, solidly navigating rough seas, rather than the Titanic, sunk by a single iceberg. Asset allocation spreads around your risk and smoothes out the ups and downs of your portfolio.
In 1990, Harry Markowitz won the Nobel Prize in economics. He developed a theory that suggests almost 92 percent of your investment returns come from asset allocation. In other words, the kinds of investments you choose are more important than the specific choices you make within each category.
A classic rule of thumb suggests you subtract your age from 100, and invest that amount in stocks, the rest in bonds. So if you’re 35, you should put at least 65 percent of your money in stocks. Personally, I always put more in stocks than that model suggests for my long-term goals, because I feel comfortable with the risk. I may end up disappointed, but I gotta be me!
Risk tolerance is a very individual decision. Once you decide how much of your portfolio you want to put in stocks, you need to choose among the mutual funds available. One classic scenario suggests your portfolio mimic the makeup of the market itself, by investing:
-70 percent of your stock allocation in a large-cap fund
-20 percent in mid-cap fund
-10 percent in a small-cap fund
Under this model, here is what a $10,000 investment would look like: -$2,500 in bonds-$7,500 in stock funds, with $5,250 (70 percent of stock allocation) in a large-cap fund; $1,500 (20 percent of stock allocation) in a mid-cap fund; and $750 (10 percent of stock allocation) in a small-cap fund
Investment advisors suggest you consider at least some exposure to stocks of companies outside the U.S. for more diversity. So of the portion of your portfolio allocated to stocks, you might consider investing:
-65 percent a large-cap fund
-15 percent in mid-cap fund
-10 percent in a small-cap fund
-10 percent in a fund that invests in foreign companies
In dollar terms, a $10,000 investment in this portfolio would look like this:
-$2,500 in bonds -$7,500 in stock funds, with $4,875 in a large-cap fund; $1,125 in a mid-cap fund; $750 in a small-cap fund; and $750 in a foreign fund. Within each of those categories (large, medium, small, foreign) you can choose growth or value styles of investing; growth funds tend to be more aggressive, and carry more risk.
Once you establish your allocation strategy you should revisit that strategy once a year—no more, no less, and realign your investments to reflect it. This is called rebalancing: It’s like driving down a highway, and your car begins to drift to one side or the other. You want to correct the steering and get yourself back in the center lane. If one of your funds has zoomed in value, it will now make up a bigger percentage of your overall portfolio than it did a year ago. You would sell some of that fund to return to your original allocation. You would take the proceeds from that sale and use it to buy more of the fund that has slipped below the original allocation.
Example: Original Allocation Strategy:
-70 percent in Snow White Large-Cap Fund
-20 percent in Bashful Mid-Cap Fund
-10 percent in Happy Small-Cap Fund
Twelve months later, the funds rise or fall in value; you now have:
-75 percent in Snow White Large-Cap Fund
-20 percent in Bashful Mid-Cap Fund; and
-5 percent in Happy Small-Cap Fund
To rebalance at the end of the year, you would sell 5 percent of the Snow White Large-Cap fund, and buy 5 percent of the Happy Small-Cap Fund.
You may have heard the classic investment phrase “buy low, sell high.” It simply means you should invest in assets when they are low in price, and sell them when the price goes up. Unfortunately, many investors often do the opposite—they see the price of stocks decline and they panic and sell. Or they notice that everyone is buying a certain kind of stock, and they all pile in after one another. But you want to be the investor who is buying when everyone else is panicking and selling; and selling when everyone else is caught up in a buying frenzy.
This takes a tremendous amount of discipline, and a realization that you’re in this for the long haul. Choosing an allocation strategy and sticking with it by rebalancing once a year helps you stay the course, and shelter your investments from your emotional reaction to what’s happening in the market.
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