It’s not a circus act. But, to avoid feeling like a clown, you’d do well to learn how portfolio balancing can mitigate some risks associated with investment volatility and maybe turn your losses into gains.
If you’ve been reading up on this blog, you already know about how diversifying your portfolio can help reduce the impact of unsystematic risks. Before you diversify your asset classes, however, you should at the very least consider portfolio balancing. Portfolio balancing and asset diversification together will help offset potential losses that might occur when employing highly volatile investment assets.
Here’s how it works
Typically, to balance your portfolio, you’d use 2 or more different asset classes. For this approach to have substantial benefit, the combination of these assets should offset each other’s shortcomings.
Let’s say you have a potentially profitable asset in stocks that is also considered high-risk due to stock market volatility. If you invest a 100% of your portfolio into this asset, you may be in for a large pay-off down the road. But, since you know that the stock market is highly volatile and is subject to many factors – you’d want to do something in order to reduce the possibility of losses. So, instead of investing 100% in a high-return-yet-highly volatile asset like stocks, you invest a percentage of your portfolio in fixed-income assets that incur a lower risk. Namely – bonds.
While you can have more than 2 assets in your portfolio at any given time, stocks and bonds serve as a prime example of how you can use two different types of assets to reduce risk and boost returns. While the stocks in your portfolio will generate more returns, bonds will mitigate the overall risk, while still providing a predictable, set amount of returns.
You need stocks and bonds to balance your portfolio, but what is the ratio? And how can you increase the effectiveness of your assets?
Your portfolio’s stock-to-bond ratio will differ during your life, mostly due to your risk tolerance and your short-term and long-term goals and the associated changes. However, there’s a general rule of thumb stating that the amount of stock in your portfolio should equal 100 minus your age. For example, for someone aged 25, their portfolio should consist of 75% of stocks and 25% of bonds, whereas for someone aged 75 it’s vice versa. Now, considering that the average human lifespan is increasing every year, the average investor is looking to build up more wealth. Thus, using 120 minus your age would be more appropriate. Especially, while you’re still on the younger end of the age spectre.
For example – you’re 30 years old, and you want to balance your investment portfolio properly. 120 minus 30 equals 90% of your portfolio should be in stocks and 10% should be in bonds. This would give you a much larger earning potential from the stock part of your portfolio, while at the same time giving you a 10% buffer. A 10% of your portfolio allocated to bonds will not entirely offset catastrophic losses incurred by stocks in case of market crash, yet it’s better than nothing.
There are also universally accepted ratios that are well known for their performance over the years. The 60/40 stock-to-bond ratio has gained widespread recognition as the ultimate ratio that provides most returns and most safety. Since 1987, this ratio has given annual returns of roughly over 9%, depending on 60/40 portfolio construction.
While the stock-to-bond ratio of your portfolio is very important, it’s also necessary to utilise your assets correctly. For instance, you already know that in order to reduce risk and increase returns, you have to diversify your portfolio. You can do this by purchasing mutual funds, instead of painstakingly accumulating stock by stock, bond by bond. Both stocks and bonds give you the option of purchasing them via index funds and ETFs, among others. This way, in addition to balancing your portfolio according to your age and needs, you also diversify the investments for only a fraction of the cost.
But, wait! The way that bonds help you reduce the overall risk for your portfolio is associated with how bonds work. Once you buy a bond and hold it until what is known as the bond maturity date, you will be paid face value for the bond, even if it has gone down in actual value while you had it. However, this severely reduces the liquidity of the bond, by forcing you to hold it until the maturity date. If bond value goes down during this period, and you have to sell before the maturity date – you will incur loss.
So, there are a couple of things to remember, when purchasing bonds in order to balance your portfolio:
- Invest in short-term bonds, rather than long term bonds, as the former are less susceptible to inflation and do not impose upon liquidity as much.
- If you purchase bond mutual funds, instead of separate bonds – you rescind the right to ‘maturity date’ as there is none. Therefore, if bond prices fall, you will likely lose money.
Here’s why timing has a lot to do with balancing – your risk tolerance is directly linked with your age. Generally, the younger you are – the higher your risk tolerance.
And there’s logic to it, too. When you’re still in your 20s or 30s, old age and retirement seem like a million light years away. Thus, taking on more risk in order to become rich (or at least financially independent) might appeal to you more. The opposite is true when you find yourself later in life, looking forward to your imminent retirement and the relish provided by the fruits of your labour. Risk would become as undesirable as ever.
This doesn’t mean that you should balance your portfolio once, when you’re younger, and then re-balance it once you’re older. In fact, advisors suggest that portfolio rebalancing should be annual or even more frequent – depending upon your plans, needs and market situation.
For example, if you have a 75/25 portfolio and your equity investments outperform the fixed-income investments significantly over the period of a year, the portfolio ratio will change towards equity. You could have an 80/20 portfolio or even a 90/10 portfolio on your hands. In order to rebalance your portfolio, you would then move the necessary percentage towards fixed-income assets.
Once-a-year rebalancing should be sufficient. However, it’s important to monitor your portfolio and make amendments when necessary.
While bond interest rates have been on a steady decline over recent decades, a turnaround may be in progress since Q1, 2022. Declining interest rates mean an increase in value, yet now bond value is bound to decline. While it may not be too much of a problem if you intend to hold the bond until maturity, it does pose a restraint on your asset liquidity. This, in turn, might turn investors towards other fixed-return assets, like CDs.
But, perhaps, the changes on the horizon will grant investors around the globe new opportunities altogether.