Everyone loves a winner. If an investment is successful, most people naturally want to stick with it. But is that the best approach?
It may sound counterintuitive, but it’s possible to have too much of a good thing. Over time, the performance of different investments can alter a portfolio’s intended purpose and risk profile. It’s a phenomenon sometimes referred to as “risk creep,” and it happens when a portfolio has its risk profile shift over time.
When deciding how to allocate investments, many individuals start by considering their time horizon, risk tolerance, and specific financial goals. Next, individual investments are selected that pursue the overall objective. If all the investments selected had the same return, that balance – that allocation – would remain steady for a specific period. But if the investments have varying returns over time, the portfolio may bear little resemblance to its original allocation.
How Rebalancing Works
Rebalancing is the process of restoring a portfolio to its original risk profile.
There are two primary methods for rebalancing a portfolio.
The first is to use new money. When adding money to a portfolio, allocate these new funds to those assets or asset classes that have declined in value. For example, if bonds have fallen from 40% of a portfolio to 30%, consider purchasing enough bonds to return them to their original 40% allocation. Asset allocation and diversification are investment principles designed to manage risk. However, they do not guarantee against a loss.
The second way of rebalancing is to sell enough of the “winners” to buy more underperforming assets. Ironically, this type of rebalancing actually forces you to buy low and sell high.
Periodically rebalancing your portfolio to match your desired risk tolerance is a prudent practice, regardless of market conditions. One approach is to schedule a specific time each year to review your portfolio and determine if any adjustments are necessary.
Shifting Allocation
Over time, market conditions can change the risk profile of an investment portfolio. For example, consider a hypothetical portfolio that was 50% invested in bonds, 10% in treasuries, and 40% in equity. For a few years, if the stock portion of the portfolio outperformed the other assets, the hypothetical portfolio may no longer reflect the initial allocation. An adjustment may be needed to reflect the original risk profile. Keep in mind that investing involves risks, and investment decisions should be based on your own goals, time horizon, and risk tolerance. The return and principal value of investments will fluctuate as market conditions change. When sold, investments may be worth more or less than their original cost. This is a hypothetical example used for illustrative purposes only. It does not represent any specific investment or combination of investments.
Disclosure:
The information provided in this blog is for educational and informational purposes only and should not be construed as investment, tax, or legal advice. Peak American Investment Advisors, LLC (“Peak American”) is a registered investment adviser. Registration does not imply a certain level of skill or training. The views expressed are those of the author(s) at the time of publication and are subject to change without notice. Any references to specific investments, strategies, or financial concepts are for illustrative purposes only and may not be suitable for your individual circumstances.
Past performance is not indicative of future results. All investments involve risk, including the possible loss of principal. You should not act or rely on any information in this blog without first seeking the advice of a qualified financial, tax, and/or legal professional who is familiar with your personal situation.
For more information about Peak American’s services, please review our Form ADV and other disclosures, which are available upon request.
Peak American Investment Advisors
2400 Dallas Parkway, Suite 100
Plano, Texas 75093