Portfolio Rebalancing

Let’s say that late last April (2011) you decided that an appropriate asset allocation for you, based on your risk tolerance, was 50% stocks and 50% bonds, and that you preferred a very simple portfolio using only 2 asset classes: US Stocks and US Bonds. So, on May 2, you invested $20,000 by buying $10,000 of Vanguard Total Stock Market Index fund and $10,000 of Vanguard Total Bond Market Index fund. About three months later, on August 8, the stock fund had declined in value to about $8,150, the bond fund had increased in value to about $10,380 (assuming reinvested dividends), and your total portfolio was worth about $18,530 (data from morningstar.com). At that point your portfolio was 44% stocks and 56% bonds; i.e., each asset class was about 6 percentage points away from it’s target allocation of 50%.

Assuming no changes in your risk tolerance or other factors affecting your desired asset allocation, you would have been wise to consider rebalancing your portfolio back to its target asset allocation of 50% stocks and 50% bonds. This could have been done by exchanging an appropriate amount from the bond fund to the stock fund (exchanging is a way to simultaneously sell shares of one fund and buy the same dollar amount of shares of another fund). With a portfolio value of $18,530, you would have wanted $9,265 in each fund, so you would have exchanged $1,115 from the bond fund to the stock fund.

Your International Stock Allocation

By investing in stocks or stock mutual funds you are investing in businesses. Should you invest only in the businesses of your home country, or is it wise also to invest in businesses in other countries?

Lumpers vs. Splitters

Among investors who agree that using low-cost index funds is the winning investment strategy, there is an ongoing and unresolved debate. On one side the lumpers believe that since markets are very efficient, the best approach is to use a few total market index funds; e.g., a total US stock market fund, a total bond market fund, and perhaps a total international stock fund. On the other side, the splitters believe that the academic research justifies slicing and dicing the stock portion of your portfolio into more asset classes; e.g., large-cap, small-cap, value, growth, developed (foreign) markets, emerging markets, REITs, etc. Depending on which book you read or which web site you visit, you can find compelling evidence for each point of view. Let’s briefly explore the debate.

Portfolio 2 (simple, moderately conservative): the fixed-income story

In this post we start digging into Portfolio 2 (from my post Some Real Portfolios). There are several interesting aspects to this portfolio, so I'll use more than one post to discuss the portfolio. In this post, we focus primarily on the fixed-income portion of the portfolio. This is likely to be of more interest to retired investors, or investors who are investing for shorter term goals (less than 10 years).

Portfolio 1: Simple, aggressive, global equity

In this post, we explore Portfolio 1 from my post, Some Real Portfolios. This portfolio is extremely simple, consisting of only two Vanguard index funds:

• 50% Total Stock Market Index (US stocks)
• 50% Total International Stock Index (non-US stocks)

We might call this as an aggressive, global equity (stock) portfolio because it is 100% invested in stocks (no bonds -- very aggressive), and has a relatively high allocation to international (non-US) stocks (hence, global).  First, let's consider the investor's willingness, ability and need to take risk, and see how this portfolio fits.

Some Real Portfolios

I thought it might be helpful to discuss some real portfolios that I've been involved in developing. I'll start with the simplest portfolios, and then move to the more complex. The idea is to expose you to a variety of asset allocations, each having been designed based on the willingness, ability and need of the investor to take risk, along with ability and willingness to handle portfolio complexity.

Asset Allocation: Part 2

Introduction

In Asset Allocation: Part 1, I discussed some of the thinking behind diversifying your portfolio among stocks, bonds and cash.  You can accomplish this quite simply with 2 or 3 low cost index mutual funds, and some highly respected financial authors and researchers recommend keeping it simple, and doing exactly this.  However, other highly respected financial advisors/authors/researchers recommend splitting your portfolio into more asset classes, and cite research that demonstrates that this has often (but not always) provided higher return with lower risk over the long run.  This is what I'll be discussing in this post.

Asset Allocation: Part 1

Asset allocation is one of the most important investment topics to understand.  At the top level, asset allocation is how you split your money between cash, bonds and stocks, each of which is a separate asset class.  There are other asset classes, like real estate and gold, but when you're getting started, you mainly need to focus on cash, bonds and stocks.  There are also further subdivisions of stocks and bonds into additional asset classes, but I'll save that for Part 2.

(Note that by "stocks and bonds" I really mean low cost stock index mutual funds and bond mutual funds, but I'll continue to simply refer to them as stocks and bonds.)