We love diversification around here. Big fans. Stocks. Bonds. We love them all. They all have places in our portfolios. We love diversification for many reasons. It dampens volatility, which should make your portfolio compound over time. A diverse portfolio can also give a boost to your psyche. The more diversity you have, the more likely there will be something working in your portfolio. That’s crucial in years like 2018, when it seemed like no asset class rose.
To maximize the benefits of diversification, you should plan how you are going to rebalance your portfolio. Rebalancing a portfolio is when you compare your current asset allocation to your target asset allocation and buy and sell things to get back to your targets. This turns volatility into opportunity. When you rebalance, you will be buying what has gone down and selling what has gone up.
If you don’t have an advisor who will rebalance for you, you should decide in advance when and how you should do it. If you don’t plan first, you’ll struggle to do it when the time comes. Rebalancing is emotionally hard. It doesn’t feel good to sell what has gone up just to buy something struggling. That’s why you need a plan rather than leaving it up to emotions.
Let’s say you have the common 60%/40% stock/bond mix. If stocks go up 10% and bonds go up 2%, you are now the proud owner of a 62%/38% portfolio, as shown below. If you see those returns annually over 10 years, it becomes 76%/24% stocks/bonds.
Without rebalancing, your portfolio will become more heavily tilted toward stocks over time. You will gradually lose the benefits from diversification. Your portfolio will become more volatile as you get older; the opposite of what you probably want.
Some people rebalance on set schedules – monthly, quarterly, annually. Some people do it when an asset class reaches a threshold limit – e.g. if you target 60% for stocks, rebalance if it goes below 57% or above 63%.
A Vanguard study shows that your returns and volatility will be similar regardless of which plan you go with. It just matters that you pick a plan and stick to it. If you don’t think you have the knowledge, the time, or the discipline to execute your own rebalancing plan, working with an advisor who stays on top of your asset allocation may be the way to go.
Rebalancing is how you maintain diversification. We love rebalancing around here. Big fans.