If you’ve read the blog for very long, you probably know that I’m a big proponent of thoughtful and customized asset allocation. The percentage of your portfolio invested in stocks, bonds, cash, and real estate should vary based on your personal financial objectives and tolerance for risk.
In fact there are plenty of studies contending that asset allocation determines the vast majority of your portfolio’s return. In other words, it doesn’t matter as much which stock or bond you choose to invest in. It matters far more how much of your portfolio is invested in stocks or bonds in the aggregate.
The Importance of Portfolio Rebalancing
If you’ve ever managed your portfolio (or anyone else’s for that matter) you also know that over time your portfolio’s asset allocation will change as the market fluctuates. If you start with 60% in stocks and 40% in bonds, you might find your portfolio weighted 70% in stocks and only 30% in bonds after an appreciation in the stock market – especially since bonds tend to fall when stocks rise.
This is why it’s important to rebalance your portfolio over time. The whole point of building a customized asset allocation is to match the risk in your portfolio to your personal risk tolerance. As your individual investments fluctuate in value, selling some of the appreciated positions and replacing them with some of the depreciated positions brings your portfolio back to its intended allocation.
For example, if a 60/40 portfolio became 70/30 after the markets moved, you’d want to sell stocks that represent 10% of your portfolio and use the cash to purchase bonds – returning to your original 60/40 allocation. Without rebalancing, your portfolio would continue to stray over time, ensuring a level of portfolio risk that’s higher or lower than you’d like.