If you have an investment portfolio, like a 401(k) from work or a brokerage account that you manage on your own, it may be made up of a range of different assets: stocks, bonds, and maybe even some cash in certain accounts. How you divvy up your assets in your portfolio is referred to as asset allocation. Pretty straightforward definition, right?
But there’s more to asset allocation than just splitting up your stocks and bonds any which way. It can be a factor in your investment strategy where you – and we’re going to borrow from the official definition here – allocate, or, divide your securities based on factors like your risk tolerance, time horizon, and even your money goals. And every so often, you might shift the percentage of your assets (aka rebalance) to make sure the breakdown still meets the intended mix as well as your needs.
Whether you’re a new investor or an old hand, we’ll review some things you should know about asset allocation and rebalancing, and how the two factors could play a role in your investment portfolio.
We gave you a brief explanation above, but in case you want a bit more information, let’s dive in with an analogy.
If you’ve ever made a weekly grocery list and divided it up by different types of foods you need to purchase for the week’s meals, you’re already dabbling in asset allocation! Perhaps you set aside a certain percentage of the budget for vegetables, a certain percentage for food staples like bread, butter, eggs, and milk. You’d figure out how much you’ll need to spend on each food group based off the meals you’re planning to prepare that week.
Asset allocation works in a similar way, just swap the food for securities in your investment portfolio. Asset allocation is basically how your portfolio is divvied up amongst various asset classes, including most broadly stocks, bonds, and cash. And when you nail down an asset mix that fits your goals, that becomes your target asset allocation, that is, the breakdown (say stocks versus bonds) of your portfolio.
As you might know, different asset classes could perform differently. So one asset class could suffer some losses while the other could be climbing higher. If your portfolio moves away from your target allocation, you can shift it back to your more ideal mix (more on that later).
Another good thing to know: your target allocation can change. For example, as you get closer to retirement and become more conservative with your investments you might want more bonds than stocks in your portfolio, so you’ll want to periodically revisit the mix to see if it’s worth tweaking.
Asset allocation sounds a whole lot like diversification. If your portfolio has a mix of different assets, that means it’s diverse, right?
Yes and no. Even if your money is allocated across different asset classes, that doesn’t guarantee a diversified portfolio. For instance, if you have 60% of your portfolio allocated to stocks, but all of those stocks are from large cap companies, you could have a diverse portfolio but still not be diversified within specific asset classes.
We’ll be honest: there’s no right answer here! Your target allocation will depend on a few different factors.
Good to know: your asset allocation can also vary across accounts. If you’re a few decades away from retirement, your IRA might have more stocks than bonds. On the other hand, an investment account that you’re using to save up for a down payment in the next few years, may be more bond-based.
Figuring out the right mix of assets might sound like a lot of work, but remember that you don’t have to go at it alone! A financial advisor can help you determine what asset allocation makes sense for you depending on your individual money picture.
Rebalancing is bringing your portfolio back to your target allocation. You’ve probably seen how shifting markets can change the balance of your accounts. Based on how the market moves, it’s not guaranteed that the original way you divvied up your stocks, bonds, and other assets will stay that way indefinitely – some assets will do better at times than others, and vice versa.
Let’s say that you decided that the best allocation for your risk tolerance and goals is 50% stocks and 50% bonds. However, let’s also say based on market activity, your stocks start outperforming your bond holding. Eventually, that 50/50 allocation might shift, and your portfolio now looks more like 65% stocks, 35% bonds. While that means your stock holdings have been performing well, you might consider rebalancing your portfolio to bring it back to your target allocation.
This might feel a little counterintuitive – why would you get out of some of your stock positions if you’re doing well? Remember that you determine your target allocation based on specific reasons. So, even though your stocks are doing well, a portfolio made up of 65% might not make sense for you based on your personal preferences and money goals. In short, rebalancing is less about chasing returns and more about managing your portfolio’s risk.
Again, how often you reshuffle your assets can vary from person to person.
Some folks choose to rebalance their portfolio on regular intervals, such as quarterly, monthly, or annually. In that case, you would go over your portfolio (either on your own or with your financial advisor) at set points throughout the year and rebalance as needed.
Another strategy is to rebalance whenever your portfolio has drifted a substantial amount away from your target allocation. You can decide how much you’re comfortable drifting and if your allocation strays from that, you may buy or sell assets to bring your portfolio back in line with your target allocation. Good to know: it’s generally recommended to rebalance once your allocation has shifted 5% or more away from your target allocation.
Whatever strategy you decide is right for you, rebalancing your portfolio can be helpful for keeping your asset allocation in check, and keeping your investments in line with your original risk tolerance.
At the end of the day, the point of asset allocation and rebalancing your portfolio is to execute the investment strategy that works best for you and your needs. Investing, and really finances in general, are super personal and how you divvy up your assets and how often you rebalance will depend on what makes sense for your personal money situation.
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