I'm sure many of you make adjustments to your portfolios in December. But how many of you take the next step and reevaluate your entire portfolio? Now is an ideal opportunity to perform three simple steps to ensure you're on the right track for 2008 - review your goals, determine your asset allocation and make adjustments as needed. Why not use the start of the new year to "take stock" of your portfolio?
Asset allocation is a major factor in long-term investment success. Most investors understand the importance of diversification - the concept of spreading your exposure over many investments to reduce the risk of any one investment. In other words, "Don't put all your eggs in one basket." But equally important, and perhaps less understood, is the idea of asset allocation - constructing a portfolio with exposure to equities (U.S. and international), fixed income (bonds), and cash suitable to your individual goals, time horizon and feelings about risk.
Here's the rub: Once you've got your portfolio in shape, things change. Markets move, obviously, and your situation can change. Either or both can have an impact on your asset allocation, and either or both can require rebalancing or reallocating.
Market forces may necessitate rebalancing. Here's a simple example that highlights how market dynamics require a new balance. My hypothetical investor is a 44-year-old with $250,000 in her retirement account. Obviously, with at least 15 years to go before retirement, she has a long-term time horizon. She also happens to be comfortable with risk, meaning she has a fairly aggressive but not unreasonable asset allocation - 75 percent of her portfolio is invested in equities with the remaining 25 percent in bonds.
Now it's January, and she decides to take a fresh look at her portfolio. Turns out the equity portion of her portfolio did quite well, posting an aggregate return of 15 percent, while the bond portion lost 5 percent. That's a great result for the years at whole; her $250,000 portfolio has grown to $275,000. But that also means that her asset allocation has changed. Now the equity portion of her portfolio represents 78.4 percent of her portfolio and the fixed income is just 21.6 percent. Her portfolio is slightly overweighted to equities and underweighted to fixed income.
If she wants to maintain a constant risk/reward profile, she needs to rebalance. To get back to her target allocation of 75 percent equity/25 percent fixed income, she should sell some of her equities and use the proceeds to add more fixed income investments. She'll be, in effect, selling high and buying low, precisely what you hope to do.