What Is Asset Allocation and Rebalancing?

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When you take a look at your investment portfolio – whether that’s a 401(k) from work or a brokerage account – you’ll see that it typically holds several different assets. Stocks, bonds, and ETFs are some common examples.

Asset allocation is how you divide up your investments among those assets within your portfolio based on factors like your time horizon, risk tolerance, and investment goals. Over time, some asset classes will potentially grow and outperform others, shifting the original allocation of your portfolio. Whenever that happens, you’ll need to rebalance your portfolio to ensure it reflects your original target allocation.

Let’s take a closer at both of these concepts and why they’re important.

Asset allocation

For those who are still relatively new to investing, you may be wondering what’s the best asset allocation to choose for your portfolio. The short answer? It depends. Asset allocations will vary from person to person since we all have different time horizons and risk tolerance. Also, what’s best for you at this time may not be what’s most appropriate for you 30 or 40 years down the road, as your time horizon and risk profile can change.

All this is to say: When choosing an asset allocation, you’ll have to consider your time horizon and risk tolerance.

Time horizon is simply how long you plan to stay invested to reach your financial goals.

Risk tolerance is your personal capacity and willingness to take on certain risks when investing.

Both of these factors can help you determine the appropriate mix of investments to hold in your portfolio. Keep in mind that your target asset allocation can change over time depending on where you are in life and your financial situation.

For instance, the target asset allocation of a young professional just starting out in their career will likely look different than that of someone who is near retirement. Individuals with a longer time horizon (with more time to ride out the ups and downs of the markets) may choose an asset allocation designed for growth. The 80/20 split is a common example, where the portfolio holds 80% stocks and 20% bonds.

On the other hand, retirees (or near-retirees) generally have a lower tolerance for risk, so their portfolios may have a more conservative target asset allocation – holding more bonds than stocks.

Good to know: Since your time horizon, risk tolerance, and goals can change over time, it’s a good idea to periodically revisit your asset allocation to make sure they still reflect your preferences and needs. If you want help setting up your asset allocation, work with a financial advisor who can help you figure out a portfolio mix that makes sense for you.

Asset allocation vs. diversification

If your portfolio holds a mix of different assets, that means it’s diversified, right? Not exactly. It’s easy to think that asset allocation and diversification are the same thing. But just because your money is allocated across different asset classes, that doesn’t necessarily mean you have a well-diversified portfolio.

Diversification is about spreading your investments among different assets as well as within an asset class. When investors look to diversify across different asset classes, a few popular types of assets can come into play: stocks, bonds, and ETFs. A diversified portfolio typically contains a mixture of these investments.

But you’ll also want to see diversification within a particular asset class. For example, if 60% of your portfolio is in stocks, you probably won’t invest all of that in the stocks of a single company or industry sector. Diversification means spreading out your stock investments across different companies or industries, so that if one particular industry falters, your other investments could help offset those losses. This is why many investors look to mutual funds or ETFs for built-in diversification.

Good to know: While diversification can help minimize risk, it cannot eliminate all investment risks. Just as diversification doesn’t guarantee gains, it also doesn’t completely shield you from losses. The goal of diversification is to help you manage risk and reward in a strategic way.

What is rebalancing?

Once you’ve set your asset allocation, it’s important to revisit it periodically. Over time, your portfolio’s original asset allocation or target allocation may have naturally shifted. This can happen when certain assets outperform others within a period of time.

For example, if your portfolio’s original asset mix contains 60% stocks, a good showing in the stock markets could increase your stock allocation to, say, 70%. When this happens, you’ll want to consider rebalancing (or resetting) your portfolio to its target allocation to maintain the original level of risk you’re comfortable with.

To some, this might feel a little counterintuitive – why would you change your stock positions if you’re doing well? Remember that you set your target asset allocation based on specific factors like time horizon and risk tolerance. So even if your stocks are doing well, the higher stock allocation in your portfolio may not be something you’re comfortable with based on your original risk profile.

Remember, rebalancing is less about chasing returns and more about managing your portfolio to keep your investments in line with your risk tolerance and goals.

How often should you rebalance?

You may want to check in on your portfolio every six or 12 months to see whether it has drifted significantly away from your target asset allocation. It’s up to you to decide how much drift you’re comfortable with. Many investment platforms, such as robo-advisors, offer automated rebalancing, which monitors your portfolio to make sure it hasn’t drifted too far from your target allocation and helps to rebalance when necessary.

Good to know: There are different ways to rebalance your portfolio – for example, by buying or selling certain assets. Some of these transactions may trigger fees or taxes. Work with a financial advisor or tax professional to make sure you understand the potential consequences and how you might be able to minimize these costs.

Reaching your goal starts with saving for it.

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