Introduction to Asset Allocation and Diversification- Part 5
This Blog is sponsored by Soundview Financial’s Retirement Savings Guide. Click here to visit Soundview Financial to get access to helpful articles, tips and resources for retirement planning.
This is the final post of our five part series on asset allocation and diversification. We end the series with a discussion on portfolio rebalancing and the role of lifecycle funds.
The most common reason for changing your asset allocation is a change in your time horizon. In other words, as you get closer to your investment goal, you’ll likely need to change your asset allocation. For example, most people investing for retirement hold less stock and more bonds and cash equivalents as they get closer to retirement age. You may also need to change your asset allocation if there is a change in your risk tolerance, financial situation, or the financial goal itself.
But savvy investors typically do not change their asset allocation based on the relative performance of asset categories – for example, increasing the proportion of stocks in one’s portfolio when the stock market is hot. Instead, that’s when they “rebalance” their portfolios.
Rebalancing is bringing your portfolio back to your original asset allocation mix. This is necessary because over time some of your investments may become out of alignment with your investment goals. You’ll find that some of your investments will grow faster than others. By rebalancing, you’ll ensure that your portfolio does not overemphasize one or more asset categories, and you’ll return your portfolio to a comfortable level of risk.
For example, let’s say you determined that stock investments should represent 60% of your portfolio. But after a recent stock market increase, stock investments represent 80% of your portfolio. You’ll need to either sell some of your stock investments or purchase investments from an under-weighted asset category in order to reestablish your original asset allocation mix.
When you rebalance, you’ll also need to review the investments within each asset allocation category. If any of these investments are out of alignment with your investment goals, you’ll need to make changes to bring them back to their original allocation within the asset category.
There are basically three different ways you can rebalance your portfolio:
- You can sell off investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories.
- You can purchase new investments for under-weighted asset categories.
- If you are making continuous contributions to the portfolio, you can alter your contributions so that more investments go to under-weighted asset categories until your portfolio is back into balance.
Before you rebalance your portfolio, you should consider whether the method of rebalancing you decide to use will trigger transaction fees or tax consequences. Your financial professional or tax adviser can help you identify ways that you can minimize these potential costs.
To accommodate investors who prefer to use one investment to save for a particular investment goal, such as retirement, some mutual fund companies have begun offering a product known as a “lifecycle fund.” A lifecycle fund is a diversified mutual fund that automatically shifts towards a more conservative mix of investments as it approaches a particular year in the future, known as its “target date.” A lifecycle fund investor picks a fund with the right target date based on his or her particular investment goal. The managers of the fund then make all decisions about asset allocation, diversification, and rebalancing. It’s easy to identify a lifecycle fund because its name will likely refer to its target date. For example, you might see lifecycle funds with names like “Portfolio 2015,” “Retirement Fund 2030,” or “Target 2045.
This Blog is sponsored by Soundview Financial’s Retirement Savings Guide. Click here to visit Soundview Financial to get access to helpful articles, tips and resources for retirement planning.
