Think about your last long road trip. Did you use a paper map to find your way, or did you rely on GPS?
These days, odds are that a GPS-enabled device guided you along. Amazingly, though, even with GPS perched on the dash, we manage to take a wrong turn, miss an exit, or get caught up in road construction.
Thankfully, the GPS device will re-calculate a new path to reach the desired destination.
In investing, it’s also necessary to periodically re-calculate to ensure you reach your destination. Rather than ‘re-calculating,’ however, it’s often referred to as ‘rebalancing,’ but the concept is the same. When your account goes off track, it’s vital that you find the quickest way back on the road to your retirement goals.
Investment portfolios go off course because some investments will outperform (or underperform) others in your account. This causes your portfolio to slowly drift from your desired mix of investments. Rebalancing is simply the process of resetting your portfolio back to your original, intended allocation.
Going back in time can help illustrate the importance of rebalancing. For example, let’s say Larry, whose only retirement funds were in his 401(k) account, sat down with his financial advisor back in 1988. Larry’s main goal was to comfortably retire when he turned 65 in 2010. With Larry’s goals and risk tolerance in mind, his financial advisor decided that the best asset allocation for Larry was a portfolio with 40% bonds and 60% stocks. Larry left that meeting in 1988 feeling confident about his prospects for retiring in 2010.
What would have happened, though, if Larry never bothered to look at his account again after that meeting?
As you can see in the chart, over the years his portfolio would have drifted away from his initial asset allocation. In fact, by the beginning of 2008 Larry’s portfolio would have held only 23% bonds and a whopping 77% in stocks, making his portfolio much riskier. In 2008, the U.S. stock market dropped 37%. Assuming Larry invested entirely in U.S. stocks, his 401(k) account would have taken a deep blow, perhaps jeopardizing his chances of retiring two years later.
Rebalancing is the key to avoiding Larry’s fate. Unfortunately, knowing when to rebalance your portfolio isn’t as obvious as knowing when to rebalance the tires on your vehicle. There’s no wobbly feeling or noisy vibration as a warning. That’s why it’s important to periodically monitor your investment account.
There are two ways to go about rebalancing. (1) You can rebalance according to the calendar (e.g., once a year each January). Or (2) you can rebalance when your investments drift from your original allocations by a set percentage (e.g., 5% in either direction). Both approaches are effective, so take your pick.
How you rebalance your portfolio isn't nearly as important as having a process in place to simply do it on a periodic basis.
Like GPS, rebalancing can unquestionably help you reach your destination in the shortest time possible. But on your journey to retirement, the difference could be a matter of years, not just minutes.