When talking about saving and investing, it often helps to unpack certain key terms that carry a lot of meaning. Asset allocation is one of those terms. The process of “asset allocation” that a financial advisor or portfolio manager undertakes for his or her clients has multiple steps. It refers, at first, to taking your savings (retirement savings or a rainy-day fund, for example) and diversifying them so that they meet certain criteria. Those criteria involve inputs such as when you will need those savings, how much risk they are willing to take, what type of return will meet their long-term expectations, and more. Once all the specific criteria have been gathered and processed, then the research for the most appropriate asset allocation begins. 

Asset allocation is then the process by which the savings are invested in various markets (also called “asset classes”), such as stocks, bonds, real estate, cash, and others. For simplicity, let’s just focus on diversifying among stocks, bonds, and cash. The goal is to create an optimal portfolio that meets the criteria presented and minimizes risk. By including different asset categories that have different return expectations (for example, we expect the value of stocks to rise more than bonds in the long-term, but bonds provide a steadier income stream) and that move up and down under different market conditions within the portfolio, we are trying to ensure that all the investments in the portfolio don’t all lose their value at the same time. In other words, there are times in the market when stocks will decline but bonds will rise, or when bonds will decline in value but stocks will increase in value. If you invested all your money in just one asset class (as in, all in stocks), you run the risk that if stocks decline in value, so does your entire portfolio. By investing in more than one asset category, you attempt to reduce the risk that you can lose your entire portfolio in a down market and ensure your investment returns will be more level over time. Asset allocation is then a diversification strategy that can be neatly summed up by the timeless adage: “don’t put all of your eggs in one basket.”

So far, this investment process is common among many investors and financial advisors. However, this is only the beginning, and what happens over the coming years is what becomes critical. The reason asset allocation is a formidable investment strategy, is that when done appropriately, you are selling some assets at high prices and buying others at lower prices.  For example, let’s say that the optimal asset allocation to achieve your goal is represented by 60% stocks and 40% bonds. Let us also imagine that the stock market goes down by 20% while bonds go up by 10%. At the end of this market event, the asset allocation has become approximately 52% stocks and 48% bonds, which is not the 60/40 mix you started with. It is very possible that the investment result is exactly what you were expecting given the market action, but a major question remains: What now?

It is here that many investors forget about the original asset allocation ratio. Many financial advisors look to reallocate once a calendar year. The most common reason for changing the asset allocation ratio is your time horizon. In other words, a 30-year old that is saving for retirement will have a greater exposure to higher return (but also higher-risk) potential asset classes than a 50-year old investor. Consequently, as the 30-year old gains in age, their asset allocation ratio will have to change and become less risky. But what is so magical about waiting a year to review asset allocation? Nothing!

Rebalancing your portfolio allocation should be done at the opportune times, not just on a predetermined date when an investment meeting on asset allocation takes place. Financial advisors have a habit of falling in love with their allocation and convincing clients that they must stay the course by saying, “you see, it worked.” And it may have worked, but the time to rebalance is right there and then. Changing the asset allocation ratio from the new 52/48 back to the 60/40 is the action that should occur, because this will necessarily involve selling stocks at higher prices and buying bonds at lower prices. Allowing the 52/48 ratio to get back to 60/40 on its own is an enormous missed opportunity.

Rebalancing is bringing your portfolio back to your original asset allocation mix. This is necessary to get back to the original optimal allocation that was designed to get you to where you want to be at retirement or a determinate day.  Realigning the asset allocation ratio not only positions the investment back to the risk and return level that you originally defined but will add a level of insurance for the future earnings of the portfolio.

Let’s put some numbers on this explanation as an example. Let’s assume the portfolio was a $100,000 investment and taking that same scenario of stocks down 20% and bonds up 10%, the original portfolio mix at the end of the market event would have had a -8% return or a loss of $8,000 (meaning the portfolio is now worth $92,000). Now let’s assume that bonds do not move over the next year. In order to get back to the original investment of $100,000, the stock market would have to go up about 17%. However, if the asset allocation were rebalanced, then the result after one year with the stock market rising 17% would be a portfolio value of about $101,000. That $1,000 has not only increased the original earnings goal, but will also grow over time, adding additional earnings to the investment and serving as insurance.

In the end, we believe in a holistic strategy when it comes to asset allocation. Reviewing your asset allocation on a calendar basis has its benefits in helping you keep track of how your allocation should change as you age, but rebalancing should also be a process of continuous monitoring to take advantage of opportunities that the markets provide.

Chief Investment Officer
Xavier Urpi

Please note that our analysis does not take tax consequences into consideration, which would add another level of analysis. However, for tax-deferred retirement accounts this methodology for asset allocation rebalancing has no tax consequence.