Your investment allocation is a unique blend of stocks, bonds, and cash that reflects your financial goals and tolerance for risk — or at least it did when you last reviewed it, perhaps, a couple of years ago?
As market performance ebbs and flows, certain segments of your portfolio outperform (or underperform) the others, causing your asset allocation to drift over time. That reduces downside protection and may result in lower returns.
Indeed, investors who hope to maintain an asset mix appropriate for their age, risk tolerance, and personal objectives should consider rebalancing regularly to bring their portfolio back in line.
- Determining your target allocation
- Buying and selling shares strategically
- Keeping tax efficiency in mind
“You don’t want to be caught off guard seeing your account value not behaving the way you expected in a volatile market due to your account being out of balance,” said Anh Nguyen, a CFP® professional with Coastal Wealth in Ft. Lauderdale, Florida.
What is asset allocation?
Asset allocation is the practice of investing in different types of financial vehicles, resulting in a diversified portfolio of holdings. It is the cornerstone of investment strategy, enabling investors to balance their need for growth with their tolerance for risk.
Most financial professionals recommend investors maintain a blend of asset classes, typically stocks (equities), bonds (fixed income), and cash (for liquidity). A broadly diversified portfolio can help provide stability in a volatile market, increasing the probability that some of your investments will zig while the others zag. Stable returns may reduce the costly impulse to engage in market timing. (Related: Understanding asset allocation and diversification)
Diversification within your equity allocation is particularly key and should include a cross-section of small-capitalization, mid-capitalization, and large-capitalization in domestic and international stocks, as well as exposure to different market sectors, such as industrials, financials, consumer staples, and health care.
Mutual funds and exchanged-traded funds are one avenue for achieving diversification without having to research individual stocks or specific equity categories. (Related: Mutual fund and ETF basics and strategies)
Some experienced and sophisticated investors also look at alternative assets, such as real estate investment trusts (REITs) and private equity funds, which traditionally have a lower correlation to market performance and can also help hedge against volatility, potentially resulting in higher risk-adjusted returns. But such alternative asset classes also generally involve greater risk.
And others look at preserving investment gains by purchasing permanent life insurance or annuities that provide some growth and guarantee returns sometime in the future. (Learn more: Taking cash off the table: Life insurance, annuity alternatives)
The right mix for you
There is no one-size-fits-all asset allocation. The correct mix differs for everyone depending on their financial profile. And it isn’t static. It changes over time, especially in retirement accounts, often becoming more conservative as we age.
A 30-something investor who is willing to assume more risk in exchange for higher return potential might opt for an 80/10/10 portfolio, with 80 percent of her portfolio invested in stocks, 10 percent in bonds, and 10 percent in cash. Her similarly aged peer might be less comfortable with downside risk and opt instead for an allocation of 70 percent stocks, 20 percent bonds, and 10 percent cash.
Investors in their pre-retirement years have less time for their portfolio to recover if stocks suffer a slide and may shift to a higher allocation of bonds, which historically have offered lower returns but also less risk. In that case, a portfolio of 50 percent stocks, 30 percent bonds, and 20 percent cash might be appropriate. Retirees might become more conservative still as they set their sights on principal preservation. (Many financial professionals urge retirees to maintain some equity exposure to offset the effects of inflation, maintain purchasing power, and mitigate the risk of outliving their savings.)
(Investor Profile Quiz: What kind of investor am I?)
“The process of determining which mix of assets to hold in your portfolio is a very personal one,” said Laurie Madenfort, a financial professional with Coastal Wealth in Ft. Lauderdale, Florida. “The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.”
While your asset allocation targets may remain constant, your portfolio performance does not. As your stocks deliver compound growth, they begin to consume an ever-growing percentage of your portfolio relative to fixed income — especially during periods of sustained stock market growth. Your stock returns will also be uneven, causing certain asset classes to become overweight.
How to fix your asset allocation
There are several strategies investors can use to maintain portfolio balance.
Many use the “constant weighting” model, also known as strategic asset allocation, in which they determine their ideal asset mix and stick with it long term, regardless of how the markets perform. If their target allocation is 70 percent stocks, 20 percent bonds, and 10 percent cash, they might rebalance any time their allocation deviates by 5 percent or more. Or, they might review their asset allocation on a fixed schedule, say, once a year, to restore their target weightings.
“Review your current mix of equities vs. fixed income and ask yourself if it’s out of balance,” said Nguyen. “In other words, does it deviate largely from your original target allocation that aligned with your investment objective and risk tolerance at the beginning? If it does, it's the right time to rebalance.”
More sophisticated investors who are comfortable with greater risk might instead attempt to juice their returns through the use of short-term tactical methods, adjusting their target weightings based on economic projections, business cycle fluctuations, and stock valuations.
Regardless of your strategy, rebalancing your portfolio is accomplished in three primary ways, said Madenfort. You can:
- Sell a percentage of your best-performing stocks which have become overweighted and use the proceeds to buy more of your underperforming stocks (that you still wish to own). It may be difficult psychologically to sell your winners, but don’t forget that those same stocks may fall out of favor next year, causing your portfolio to suffer a bigger slide than you bargained for. It also commits you to a program of buying low and selling high.
- Purchase new investments to restore your target weightings.
- Invest a higher percentage temporarily to your underweighted asset categories if you contribute regularly to your portfolio.
Tip: Rebalance with tax efficiency in mind
As you monitor and tweak the composition of your investment portfolio, be aware that where your assets are held can have a significant effect on your long-term returns.
“When it comes to rebalancing, you first need to identify where your asset is located,” said Nguyen. “In tax-deferred accounts, such as your 401(k) and IRA, you can have higher frequency of rebalancing without concern of generating taxable income. Thus, you can set a lower drift to trigger the rebalancing, such as saying that if stocks increase by 10 percent, your portfolio will be automatically rebalanced. In taxable accounts, the rebalancing needs to be well-thought-out as it does create a tax drag on portfolio return.”
The degree of that drag depends on your individual tax bracket.
“If you’re in a high tax bracket, you may want to allow for a larger drift from original allocation before rebalancing,” said Nguyen.
To maximize efficiency while rebalancing a taxable brokerage account, Madenfort suggests investors consider tax-loss harvesting at year-end, in which you sell some of your securities that have produced a loss to offset a portion of your capital gains. Investors can then use the proceeds from selling their poorly performing assets to purchase other securities that may grow over time, which would further help them recoup their losses. (Learn more: Year-end tax-planning moves)
“End of year tax-loss harvesting involves selling an investment that has lost value—to create a loss—and replacing it with a similar investment,” said Madenfort. “You can then use the investment sold at a loss to offset the gains on appreciated assets that were sold.”
The IRS permits taxpayers to offset all capital gains in a portfolio in a given year with their investment losses. Any excess loss can be used to offset ordinary income up to $3,000 per year ($1,500 for married individuals who file separately) until the loss is used up.1
Investors should be aware of the wash-sale rule, however. Taxpayers cannot claim a deduction when they sell or trade stocks at a loss and then repurchase those shares (or a substantially identical security) within 30 days before or after that date. Many people opt to consult a tax specialist as tax-loss harvesting can have a profound effect on long term returns.
Derek Horstmeyer, a professor of finance at George Mason University’s School of Business in Fairfax, Virginia found that, on average, an investor can boost their equity portfolio’s annual return by 1.1 percent points to 1.42 percentage points through tax-loss harvesting. He found that the value can be even greater (up to 3.2 percentage points of additional return) when markets are more volatile, producing a larger number of losing stocks, or when capital gains tax rates are high, either because the federal government raised rates or an investor is selling short-term holdings. Long-term holdings (stocks held for more than one year) are taxed at the lower capital gains tax rate (a maximum of 20 percent in 2022), while short-term capital gains on stocks owned for one year or less are taxed as ordinary income (a maximum of 37 percent in 2022).
Your asset allocation is a direct reflection of your financial objectives, appetite for risk, and time horizon to retirement. But it must be monitored carefully.
Without intervention, your weighting of stocks, bonds, and cash will drift over time, which may lower your risk-adjusted returns. A MassMutual financial professional can be instrumental in helping you maintain an investment allocation that helps you reach your financial goals. (Need a financial professional? Find one here)
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1 Internal Revenue Service, “Helpful Facts to Know About Capital Gains and Losses,” Nov. 2, 2021.