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.

Pick Your Poison (You Can’t Avoid Risk)

No matter how you choose to save and invest, you are taking some type of risk. This is obvious if you are investing in stocks (including stock mutual funds), but it may be less obvious if you are simply keeping all of your money in a savings account. Stocks are clearly risky, since values can fluctuate dramatically. What you may need to think a bit more about is that if you keep all of your money in a savings account, you are taking the very real risk that after taxes and inflation, your savings will lose purchasing power over the years. One of the most important steps in developing an investment plan is to think clearly about risk, and decide what types of risks and how much of each type of risk it is appropriate for you to take.

Risks of Investing in Individual Stocks

For the vast majority of individual investors, investing in individual stocks, as opposed to mutual funds or ETFs, is a losing strategy. This assertion is based on financial theory and vast amounts of empirical evidence. Unfortunately, most of my own experience also is consistent with this assertion.

High Returns, Low Risk! (or Financial Porn?)

On the cover of a recent issue of a major national financial magazine, written in big block letters was: HIGH RETURNS – LOW RISK. This is a blatant example of what many financial authors refer to as financial pornography. I already discussed my disdain for most financial news in my February 2010 post Financial News: Worse than Useless!, but this headline was so appallingly ridiculous that I couldn’t resist commenting on it.

A Conservative Approach to Investing

Not everyone agrees that you should invest in stocks to meet critical financial goals. It’s probably a good idea to at least consider this viewpoint, and familiarize yourself with a conservative alternative investment strategy. In the end, you must decide for yourself how much risk is appropriate for you, and make your investment decisions accordingly.

Risk Tolerance

Before I get into details of the portfolios presented in the previous post, it will be useful to discuss risk tolerance, since it's so fundamental to making investment decisions.

In his book, The Only Guide to a Winning Investment Strategy You'll Ever Need, Larry Swedroe breaks down risk tolerance into three components:

1. The willingness to take risk
2. The ability to take risk
3. The need to take risk

Time, Inflation, and Uncertainty

This article discusses a little of the theory behind why investors expect to make money on investments, and why they expect to make more money on some investments than others.  This post is a bit more theoretical than most so far.