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What Should You Do When The Market Drops? Get Your Asset Allocation On Target

You wouldn’t drive your car forever with unbalanced tires, and you shouldn’t let your investments run unbalanced forever either. Learn why in today’s Richer Life podcast episode, where we cover rebalancing portfolios. Learn why this is critical to financially living a richer life, and discover why risk tolerance is one of the most important concepts to helping you get better investment returns.

Don’t rush to sell when the market drops; instead, see how rebalancing your portfolio can help get your asset allocation on target so you can handle the market ups and (unfortunately) the inevitable market downs. Listen to the full episode, and read the transcript below:

Welcome to this episode of Richer Life. Today, I want to talk to you about rebalancing. Of course, I’m talking about investment rebalancing.

I have a story from when I was around 15 years old, and for a very short period of time I worked at a tire company – so basically, I would rebalance tires. I would fix flat tires, and I hated it, but that’s a different story for a different time. The point of rebalancing those tires though, is when you’re on the freeway driving 60 or 70 miles per hour; if the tires aren’t properly balanced, you’ll feel and hear the car shaking, and it just won’t ride very well. So what we do is, we look at the tire, we run it and we put weights where the weights need to be in order to have balanced tires, so that our ride is smooth. Similarly, we do the same thing when it comes to our investments. We rebalance our investments. But, what does that mean?

Imagine if you had a portfolio and you could predict the future. How cool would that be? And you knew exactly what investment or what fund was going to do the best over the next five years. What would your investment allocation look like, if you knew which investment was going to perform the best? Would you have 10 or 15 different investments? No. You would just have the one – the one that you knew was going to perform the best.

Why do we have asset allocation? Why do we do asset allocation? Why do we have all these assets and all these investments in our portfolio? Well, the simple answer is, we can’t predict the future. We don’t know what that one investment is going to be that’s going to perform better than all of the others. So what do we do? We invest in different investments. We spread our investment dollars around into different asset classes. We do this for a couple of reasons. One, is that we want a good return, and different assets will produce different returns, and we want to maximize our ability for our portfolio to grow. We also want to reduce our volatility and reduce the risk that our investments are going to go down in value, so this is another reason why we spread our money around. Again, we can’t predict the future. We don’t know which investment is going to do better than all the others. This also means that we don’t know which investments are going to go down in value, or even, if or when they’re going to go down in value. So this is why for most of us, we don’t have all of our money in the most aggressive growth-oriented investment that we can find. We might have some of our money there, but we also some money in bonds or real estate, because we don’t like the ups and downs in the market. Actually, let me rephrase that.

We don’t mind the ups in the market. That’s never a problem. It’s always the downs. It’s always when the market goes down by 10 percent, or 15 percent, or even two or three percent where we start to get nervous, where we look at our portfolio and all we see is red on a particular day and we start thinking to ourselves, Oh, what am I doing? Just yesterday I had this amount of money and today I’ve lost this amount. Gosh, I sure wish I would have sold yesterday. That way I can lock in my gains. Well, this is just human nature. We hate to lose. In fact, there’s a Nobel prize winning economist whose entire theory was about loss aversion and how we as humans dislike losses much more than we like gains.

So we’re designed to not like losses. Again, much more so than how much joy we get from a gain. And so this is why we have asset allocation. We spread our money around in attempt to get a good return, but that we don’t go crazy in the process with the volatility in the market.

Knowing your risk tolerance is very important, and I know it’s not sexy, right? We want to learn about what Netflix is doing and Amazon – that’s really cool to talk about. Risk tolerance, now? Not so cool. It’s kind of boring actually, but don’t let that fool you. Risk tolerance is one of the most important concepts for you to get a good handle on that will help you get a better investment return. So why is that? Why is risk tolerance so important? Well, let me tell you a story from one of my clients. This occurred maybe four years ago.

I get a phone call from a woman and she’s not a client at the time, but she tells me that she’d been working with another advisor for several years and she thinks her returns are okay. There’s no problem there, but she just feels like there’s something wrong. She doesn’t know why. She doesn’t think that she’s invested badly. She just tells me that she’s got this feeling like something is not quite right. And so I say, “Okay, well go ahead and send me your account statements. Let me have a look and see what you’re in, what you’ve been doing, what the performance has been, and I’ll give you my honest impression.”

So she sends the statements over, and I start to go through them, and something strikes me right off the bat. What she has is a portfolio that is almost 100 percent invested in stocks. Okay. So you might be thinking, “Well, maybe she’s young. Maybe that’s not a problem.” Well, she wasn’t young. She was actually going to retire, and at that point, it was in about two years. So she was retiring in two years and her entire investment portfolio, her entire retirement portfolio was in these statements that she sent me. And like I mentioned, it was almost entirely in stocks. Okay. So I dug a little deeper. Well, what kind of stocks does she own? Turns out about half of her portfolio is invested in internet technology stocks, and most of these are from China. Yeah. Her retirement nest egg, something that she’d worked hard for 40 years to accumulate almost all of it in stocks and a good majority in technology companies in China. You might not know a lot about risk tolerance, but you probably get where I’m going with this.

Do you think it makes sense for her to have all of her money so close to retirement invested in stocks, and then, even more so, invested in high risk technology companies from China? The answer’s probably no, and when I explained to her what she owned, she was shocked. She had no idea she had this money invested the way it was. But again, I go back to the question, who cares?

Why is risk tolerance so important? Well, here’s why it’s important. It’s because if we experience – and maybe I should say when we experience, because it’s inevitable – when we experience a market decline of 10 percent of 15 or 20 percent or more, the worst thing that you can do is overreact and sell at the bottom. That’s natural. It’s the instinct that we all have. We see the losses, we see the red, and we start thinking, “Oh my gosh, it’s just going to keep going down. I’ve worked so hard for this money. I don’t want to lose anymore.” That’s an absolutely common natural reaction. There’s nothing wrong with thinking that way, but what’s wrong is acting on that.

Now, listen, we are not wired to be good investors. We’re just not. Humans are highly emotional. We’re reactive. We hate losses. We’re always looking for the next big thing. If you add all that together, when it comes to investing, we’re just not designed to be good investors. And unfortunately, this plays itself out for many investors; they make short term decisions. They make emotional decisions. They react to things in the news, and as a result, they get returns that are less than what they should be getting.

Let’s go back to rebalancing. In order to have a risk tolerance level that we’re comfortable with, we have to have an idea of what an appropriate asset allocation should be. Meaning, how much should we have in stocks, how much should we have in bonds, how much should we have in real estate or cash? That is asset allocation, and once we know what we’re comfortable with when it comes to our risk tolerance – our ability to sustain through those down periods – then we know what our asset allocation should be, but here’s what happens.

For example, in 2017, the US stock market was up over 20 percent. So, let’s imagine that you knew your risk tolerance, and you knew that an asset allocation that you could live with (and more importantly, sleep with) was 60 percent in stocks and 40 percent in bonds. After a year like last year, when stocks went up so dramatically, if you then did another snapshot of your asset allocation, what would you find? Well, because stocks did so much better than bonds last year, what you would find is that your asset allocation, instead of being 60 percent to stocks and 40 percent to bonds (maybe that’s what it was at the beginning of the year), at the end of the year, it may have been 70 percent to stocks and 30 percent to bonds. This is again, just because stocks did so much better. So what do you do then? Well, this comes to the idea of rebalancing.

Rebalancing is the process of shifting your asset allocation, making trades, making sells and buys to get back to your target allocation. So in this case, if all of a sudden you looked at your asset allocation and you had 70 percent to stocks and 30 percent to bonds, in order to get back to target, you would have to sell 10 percent of those stocks and shift those into your bond portfolio. Doing so, most likely one of the ramifications is that you would have to pay some tax; because those stocks went up in value, when you sell them, you’ve then realized gains, and those realized gains might be capital gains, so you might have to pay some tax. So that’s the downside: you may owe some tax.

But let me tell you, the upside, the benefit from rebalancing is important – it’s so important. Now what you’ve done is you’ve taken a portfolio that is outside of your risk tolerance – you determined before that 70 percent is too much in stocks. You couldn’t handle the ups and downs, and you’ve shifted it into an allocation again that you can live with and sleep well with. So that’s the important thing about rebalancing, but it also works in the reverse.

So let’s imagine we start a year where you have 60 percent in stocks and 40 percent in bonds, and that feels okay to you. That’s no problem. Now let’s say that year, the market goes down, the stock market drops in value, and now all of a sudden because stocks have done poorly at the end of the year, you run your asset allocation again, and you see that you only have 50 percent in stocks now and 50 percent in bonds. The appropriate thing to do is to get back to your target allocation, and that would be then selling some of those bonds, shifting that cash into stocks to get you back to the 60/40 portfolio.

Rebalancing is really selling winners, taking some of that money off the table and shifting it into other assets. It can also be buying when the market is down and getting your asset allocation back to target. So that’s really the important thing about rebalancing. So the question is, how often should you rebalance? So there’s different theories and different research on what’s appropriate, but I would encourage you to at least look at your portfolio and asset allocation at least annually. In my firm, we look at it all the time. We want to make sure we’re staying on target, that we’re not deviating from our client’s portfolio allocation more than just a certain amount. So, what that requires is that we’re running these asset allocations, we have targets, and we’re just comparing them against each other.

For you, I would recommend doing the same thing: figuring out what is an appropriate risk tolerance for you, creating an asset allocation that matches that risk tolerance, and then occasionally – maybe it’s once a month, maybe once a quarter, but at least once a year – making sure that you’re in that target range, so you’re not too little in stocks or not too much in stocks.

So if you have any questions about rebalancing or asset allocation, feel free to send me an email. If you have some ideas for future podcasts, I would love to hear about them, or if you have specific questions, maybe I can answer those on the next podcast. Thank you so much for listening and I look forward to hearing from you in the future.