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The first and foremost decisions for an individual investor is to determine his or her financial goals, assess his or her risk tolerance, and then develop an investment portfolio to allow one to reach those financial goals. Financial goals might be saving for retirement, a child’s college education, disbursing income while in retirement, or most any other thing that requires money to be paid in the future. Risk tolerance involves an individual investor’s willingness to take on volatility and variability in the performance returns of financial or real assets. Some investors are fine with the sometimes wild gyrations of the stock market. They might be able to withstand a 20% decline in the value of their investment portfolio and still not panic and sell. Other investors are more risk averse and do not want to see so much volatility in their investment portfolios. However, they may know they need the growth in their investment portfolio, so they reduce their exposure to stocks. Lastly, some investors may be nearing their financial goal and need to ratchet down risk in order to have enough money by not losing principal. The final step is to construct an investment portfolio that brings the two together. The financial goals can be reached but within the parameters of the investor’s risk tolerance. Note that risk tolerance in a general sense refers to the volatility of assets in one’s investment portfolio. For instance, US Treasury bills are much less volatile than stocks.

Now the financial markets will change over time as prices go up and down. Therefore, the original allocation (percentages) to stocks, bonds, cash, or other assets in the investment portfolio will be different than the one after one year goes by. It would be markedly different after five or ten years go by. That is where rebalancing your investment portfolio comes in. In this first part of this three-part discussion, I will focus on the easiest way to rebalance an individual investor’s portfolio. In the next two parts, I will expand the notion of rebalancing. In its simplest definition, rebalancing one’s investment portfolio refers to the periodic changes made to bring the investment portfolio back to the original allocation to the various investment selections. Let’s explore why this should be done.

Due to the natural ups and downs of the financial markets, an individual investor’s investment portfolio will change in composition. Remember that an investment portfolio is initially set up to allow the individual investor to reach his or his financial goals while still adhering to the amount of risk that he or she is willing to take. Well, after a year goes by, the chances are very good that the amount of money invested in stocks, bonds, cash, etc. will have changed. Thus, the investment portfolio may be more risky or less risky than intended. Moreover, the investment portfolio may not be on track to allow the individual investor to achieve his or her financial goals which is the overall goal to begin with. Additionally, rebalancing allows the individual investor to “sell high and buy low” in general. Stocks and bonds have a way of getting too expensive or too cheap as time goes by. However, the individual investor can sell the asset class that has gone up and use those funds to buy the asset class that has gone down. The technical term that you might hear is reversion to the mean. That means that over long periods of time, financial assets tend to produce an average rate of return. Hence, a rate of return much higher than the average for several years is normally followed by a period of lower returns than the average. Now let’s turn to an example with actual numbers to make things much clearer.

We can take the following scenario with various assumptions. They are as follows: the individual investor has a portfolio of $1 million at the beginning of the year, the asset allocation is 60% stocks ($600,000), 30% bonds ($300,000), and 10% cash ($100,000), during the year the stocks gain 10% ($60,000), the bonds lose 2% ($6,000) and the cash earns no interest, and, finally, the individual investor is committed to rebalancing the investment portfolio at the end of every year.

Here is the scenario:

1) Investment Portfolio at the Beginning of the Year
Type of Asset Dollar Amount Percentage
Stocks $             600,000 60.0%
Bonds                300,000 30.0%
Cash                100,000 10.0%
Total $         1,000,000 100.0%
2) Investment Portfolio at the End of the Year
Type of Asset Dollar Amount Percentage
Stocks $             660,000 62.6%
Bonds                294,000 27.9%
Cash                100,000 9.5%
Total $         1,054,000 100.0%
3) Investment Portfolio After Rebalancing
Type of Asset Dollar Amount Percentage
Stocks $             632,400 60.0%
Bonds                316,200 30.0%
Cash                105,400 10.0%
Total $         1,054,000 100.0%

As you will note above, the investment portfolio starts out with the intended asset allocation for this individual investor. However, at the end of the year in accordance with the rate of return assumptions, the investment portfolio is quite different. In fact, the percentages for each asset class have changed. In the scenario detailed above, the investment portfolio at the end of the year is more risky than at the start of the year. That is where the rebalancing comes into play. In order to get the investment portfolio back to the original asset allocation, stocks need to be sold and the proceeds invested in bonds and cash. It is fairly easy to come up with the necessary purchases and sales by multiplying the total balance at the end of the year by the desired percentage for the investment portfolio for each asset class. That step will show how much should be bought or sold in order to restore the investment portfolio to harmony.

Please note that the $1 million and asset allocation types and percentages were selected for the purposes of illustrating the concept of rebalancing. The scenario listed above will work with any investment portfolio dollar amount. In addition, there is no reason why more specific asset classes cannot be added to the investment portfolio to match your individual investment portfolio (e.g. large cap stocks, international stocks, emerging market bonds, etc.). As long as you have the desired percentages for your portfolio, you can go through the same process in the example above in order to rebalance your portfolio.

In summary, rebalancing on a periodic basis is a way to ensure that the individual investor is on track to achieve his or her financial goals while not taking on too much or too little risk to get there. It is a way to stay on the path to one’s financial plan. Normally individual investors will rebalance their investment portfolios once a year, typically at the end of the calendar year. However, there is no reason why the length and/or time of the year cannot be altered. For the purposes of simplicity, a hard and fast rule of each year at the end of the year is usually the best rule of thumb when it comes to rebalancing for most novice individual investors. One of the other benefits is that rebalancing allows individual investors to not try and time the market or stay with a certain type of investment too long. As a personal anecdote, I have an uncle who got caught up in the Internet Bubble of the late 1990s into 2001. He devoted more and more of his retirement portfolio to technology stocks. When the bubble burst, his investment portfolio was devastated. Unfortunately, he had to delay his retirement by nearly ten years due to this mishap. Adherence to a strict schedule and rebalancing plan acts a buffer against occurrences like this. It really helps to take much of the emotion, which most investors of all types struggle with, out of investing.

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