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Investing Is A Balancing Act

Virtually every long-term investor, from the largest corporate pension fund to the individual 401(k) contributor, practices some form of asset allocation in their portfolio. They decide up front what percentage they want to┬áinvest in cash, bonds, stocks and alternative investments. Asset allocation is a crucial part of any investing strategy; studies have shown that it can account for more than 90% of the variation in a portfolio’s quarterly returns. But an investing strategy based on asset allocation is a balancing act, and one that individual investors often get wrong.

Let me be clear. I believe that an asset allocation strategy, based on a thorough understanding of the investor’s goals, time horizon and tolerance for risk, should serve as the guiding force in the management of any portfolio. In order to be effective, however, the investor, or his advisor, must be very methodical about keeping those asset classes in the right balance. That’s why it’s vitally important to periodically review the asset allocation, and rebalance as necessary back to those established target percentages.

If, because of market fluctuations, the actual asset mix has changed significantly, there is a risk that long-term investing goals will not be achieved. In addition, investor objectives might change over time, and it’s important for the asset allocation scheme to change accordingly. When investing for a child’s education, for example, you will not want the asset allocation to be the same at age 17 as it was at age 10. As the college years approach, security will become more important than high returns.

More importantly, rebalancing allows investors to use market fluctuations to their advantage. As a simple example, assume a portfolio has an allocation target of 60% stocks and 40% bonds. If the actual mix moves to 50 – 50, this means that bonds have outperformed stocks over that period of time. To rebalance back to the target allocation, the investor would sell bonds and buy stocks, presumably when bond prices are relatively high and stock prices are relatively low. Not only is this the essence of “buy low, sell high” investing, but it places more emphasis on long-term objectives rather than short-term emotions.

Lastly, periodic rebalancing provides an opportunity to reassess the specific holdings in the portfolio. While I do not advocate “chasing” the highest rated mutual funds or the hottest stocks, I do think it’s important to weed out the chronic underperforms and seek better alternatives. And for mutual fund investors, it’s a good time to review expense ratios and other fees as a way to minimize investing costs. Future returns are always uncertain, but future costs can be measured, and therefore should be managed.

So next time you receive an account statement, don’t just review your portfolio’s performance. Be sure to look at your asset allocation as well. Make sure it reflects your objectives, your time horizon, and your feelings about market risk. Rebalancing your portfolio, particularly when the market is at its most volatile, will bring discipline to your investing strategy, and keep you on track toward your long-term goals.

Kevin Fix