Wednesday, February 29, 2012

Diversification , Allocation and Rebalancing - When to do it and How Not to do it.

There once was a time when an investor could follow the example set forth by one Rip Van Winkle and effectively sleep through his investing life and "wake up" at the end, ready to retire and life the good life. Or maybe that was never true. Maybe that's always been a fable. I don't know. What I do know is that now is not the time be a Rip Van Winkle with your investments.

There are two basic reasons this is true:

1. cyclical rotation.
2. volatility.

Cyclical rotation.

10 years ago, banks and airplane stocks may have been roaring, but you would not have wanted to be holding them through the 2008-2009 period. One could argue they are a good buy at today's prices, but you would be hurting had you held onto them. Same was true of tech stocks at the start of the new millennium. The same will be true of today's hot sector too.


The trend since 2000 has largely been one of uncertainty, and uncertainty breeds volatility. This trend has only been amplified by the events of the housing collapse of 2008 and the debt crises of the developed nations.


If your portfolio represents a pie and the entire pie is your entire money you have invested, then diversification is simply how you divide your portfolio pie.
My kind of pie.

It may be split among stocks, bonds, cash, real estate and commodities but that is largely dependant upon these 3 factors:

  • Your objective.
  • Your risk tolerance.
  • Your time frame.

You're going to (or you should) invest differently for retirement than you would for buying a new house. One you have decades of time to amass wealth (retirement) while the other is typically less than a decade. That time frame may affect your risk tolerance, or you may just be sensitive to risk no matter the objective. Either way, how you feel about risk will affect what you put your money in.

But it's not that simple...

Say you start your portfolio at 75% stocks, 25% bonds - this is a simple scenario for example purposes. Over time, that allocation will change. Let's suppose that stocks go on a tear and bonds languish. A few years go by and now your pie looks more like 85% stocks and 15% bonds.

Who cares, right? Your portfolio grew, so it's good. But what if stocks take a dive? You now have far more of your pie in stocks and so you will take a bigger hit. The key to avoiding this situation is called rebalancing.


Rebalancing is simply re-adjusting your portfolio allocation to realign with your original (or current) target allocations. In the example above, you would sell some of your stock holdings and increase your bond investments to get back to your target 75/25 allocation.

But there's one more level to allocation...


"How you allocate within an asset class is as important as how you allocate between asset classes."
-Jim Randel, author of

Many individual investors practice a kind of diversification in name only, and don't even know it. For example, let's say you take your 75% to be allocated to stocks and pick 3 different stock ETF's:

  • Vanguard's VOO

Each of these is a prominent, broad based stock ETF which is what you would want. The problem though is that each one is an S&P 500 Index ETF, meaning that each track and hold the same basket of stocks. You have essentially tripled your fees by diversifying in fund companies, while not diversifying your holdings.

This is why it's important to look beyond performance and fees when picking a fund. You should also look at the fund's holdings to make sure you keep any overlap to a minimum. It's nearly impossible to eliminate overlap because some companies may be considered growth by some fund managers and value by others.

Some thoughts on rebalancing.

Beyond the periodic realignment of your allocations to your desired targets, you may want to reevaluate your target allocations from time to time as well. That is - should you change the percentage of those pieces of pie.

One factor that should trigger a change is nearing the retirement red zone. This is the period before retirement, usually about the 10 year mark. By that time you want to begin decreasing stock and growth allocations and increasing bond, income and cash allocations. Another factor that may change your target allocations is the state of geo-politics and world. Jim Randel recommends assessing how you feel about geo-politics at least once a year and asking yourself whether you feel expansive or contractive. Let that color your allocations for the year ahead as well, just don't use that as your only metric.

You can watch an interview with Jim Randel below:


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