Where has the time gone!? We are already in Week 4 of our Blog Series on Investing! And as of last Wednesday, it is officially fall!
This week we are diving into the concept of rebalancing our investments, which is a great topic to follow up on last week’s talk about risk.
If you are just joining us for the first week, you can get up to speed here by reading our first 3 weeks of material at the links below.
Before we get started, this blog does not serve as investment advice or a recommendation. This post is purely for educational purposes. Please consult your investment professional or financial advisor prior to making any changes to your investment strategy.
To get started this week, we are going to make a quick stop to a completely different topic, but one that should help us understand the concept of rebalancing as we go along.
It’s a topic that we all talk about on a daily basis… food.
I am sure I am not the only one reading this who remembers some of the earliest math problems we were tasked to solve as a child.
The kind of math problems where you have buns that come in packs of 10, and hot dogs only come in packs of 8. The goal of the math exercise is to figure out how many packs of each you would have to buy to make sure you don’t run out of either. You remember these, right?
For those of you mathematicians out there, you already know the answer is 4 packs of buns, and 5 packs of hot dogs. The goal of the problem is to find the right “balance”, or the equal number of buns and hot dogs to not let any go to waste.
Investing is no different. Once we know what our desired balance of risk and reward is, we need to maintain the balance over time.
I would challenge you to dig out the last few statements from your investment accounts and see if your risk tolerance (link a bit later) matches up with your current allocation.
Also, you should be able to tell how often or if at all your financial advisor is making these reviews and getting you realigned based on the trading activity of the account.
I’ll leave a question box at the bottom in case you need any help!
As we learned in our last few weeks of material, not all areas of our investments will grow at the same rate, which can become a problem if left unattended. This chart from last week illustrates the growth of different stock funds and a bond fund.
Rather than stick with hot dogs and buns for our analogy this week, we are instead going to go full-blown Midwest (I am from Wisconsin after all!) and use a farming analogy instead.
I can’t take full credit for this one, but it was a compelling and really interesting lesson I learned from a former boss of mine in making things easy to understand.
Last week, we talked about how stocks are typically more growth-oriented than bonds are. They serve two very different purposes in our portfolio.
We also learned that stocks can do very well, or very poorly over a short period of time, and bonds typically will be more stable over the course of the time we invest in them.
This concept is no different in the agriculture world. Each year, farmers spend a ton of effort and resources seeding their fields. Some years will be great (good weather, enough rain, no natural disasters), while other years will be full of events that prevent the farmer from producing enough.
Stocks are exactly the same. A healthy economy usually provides the right conditions for a company to grow, and as a result, the stock price will usually grow, too.
But what about the tough years? What exactly do we do?
Well, before just being able to run to the grocery store and buy some food at a moment’s notice, farmers had to deploy a different strategy.
They had to preserve their food, and one of the earliest methods in recorded history of doing this was pickling their vegetables. So yes, today we will be talking about stocks, bonds, cucumbers, and pickles.
As you can probably tell from the paragraphs just before this, stocks and cucumbers are going to fall into the same category. At some point, we have to plant seeds (make an investment of time, energy, resources) and hope that at some point in the future, we can harvest the fruits of our labor.
Along the way to harvest, a few things will happen:
- Some of the seeds we planted will not sprout at all.
- Some of the sprouted seeds will die out due to lack of water, sunlight, or ideal weather conditions. We can’t forget about weeds too!
- Some of the surviving plants may be subject to disease, or animals who may eat them before we get out to pick them.
- Of the plants that are still left at harvest, some will be more desirable to eat than others.
The key thing to remember here is, there will be inefficiency. If we have too much inefficiency or loss of our crops, we will be in big trouble!
This is no different in the investment world, and the nightmare stories you hear of “losing everything” usually are a result of the investment strategy having too large of reliance on the continued growth of the stock portion of our portfolio.
To combat this, we need to build in some type of systematic preservation of the crops or investment returns we produce.
In the case of a farmer, having more cucumbers than he or she knows what to do with, there is now a second option. They can preserve them, or turn them into pickles before they go rotten.
This is no different than the long streak of positive investment returns we sometimes see. If we hold too long, and the investment opportunity goes rotten, our returns can vanish in the blink of an eye.
Our economy at times can get overheated, overripe (the dot-com bubble, the housing crisis) with optimism, and when it all comes crashing down, the effects can be devastating.
This is no different than going through incredible years of production, only to be followed by drought or tough weather season where there are little to no crops.
Another common issue is, we have no way to plan for this. Weather and the economy can be equally unpredictable. It is not necessarily a bad thing though, at least for the well-prepared farmer or investor, and can allow us to live by the “buy low, sell high” mantra we so commonly hear.
I will share more about how unpredictable events shaped my journey as a financial planner in our November 12th blog. Get subscribed below so you don’t miss this one!
This is exactly why we have to maintain the balance as we go and as our life evolves. Our state of balance (or Harmony….) will change as we add or remove pieces of our life.
So what exactly do these pickles do for us?
In the tough years, they give us something to eat or something to sell and create the income we need to purchase the seed we will need in order to try again next year.
This is no different with your investments. The bonds in our portfolio (not ALL bonds are equal… which is why it is important to discuss with your financial professional, and why this isn’t advice) will allow us to have some degree of stability to either convert to cash, or to reinvest back into the stock portion of our portfolio to maintain the balance we have determined to be the fit for our financial life.
Let’s take a deeper dive into this now that we have the conceptual information laid out.
For the sake of simplicity, we are going to start off with the assumption that we are moderately aggressive, and have determined our ratio of Stocks (cucumbers) to pickles (bonds) is 60% Stocks /40% Bonds.
You can take a risk tolerance questionnaire at the link below to learn what yours may be.
If you have questions after taking this, don’t hesitate to reach out. I’d love to hear your score as well!
For simplicity’s sake, let’s say we are going to be investing $100,000. Using our 60% Stock / 40% Bond portfolio, that means we will have had $60,000 to invest in stocks, and $40,000 in bonds.
So with our initial starting point determined, let’s see what happens when our crops and investments grow over the course of one calendar year.
As you can see, over a year’s time, our stocks and bonds have both grown. The stocks have grown more than the bonds, and now our state of Harmony is out of balance.
While our example today is just a shift of a couple of percent, over time this can continue to add up and put our portfolio well beyond our level of desired risk. If we go back to our lesson last week, you can see what this new balance of assets does to the amount of risk and change we could experience in our portfolio.
This means we are now overexposed or taking on more risks than we either want or need to take based on the goals for our accounts.
The same is true for the farmer example… they have more than they need for cucumbers, and if they don’t act soon, those are going to spoil and be useless.
What we need to do next is make some changes. In our portfolio, this means selling off some of the stocks and buying more bonds to get back to our original 60% Stock / 40% Bond portfolio.
This is no different than taking some of our cucumbers and turning them into pickles, which are much more stable sitting on the shelf than an unpickled one would be.
But what if we didn’t rebalance? What if we just let it ride?
Let’s fast forward now, and see what happens when the economy goes down across the board. Both our bonds and stocks have now declined.
As you can see, the bonds moved down less than stocks. They are the stable piece, the pickles that we can eat when we are facing a bad farming season.
For those nearing or in retirement, this can be the portion of the portfolio that can be converted to dollars and used to fund living expenses. We’d much rather do that than sell off the stocks which are now 17% lower than when we bought them.
Had we rebalanced before the crash, the excess portion of the stocks would have been put into bonds, and only declined 5%.
But for younger investors who are just getting started, this still plays an incredibly important role. Had we captured some of those gains before, we would now convert some of the bonds (or pickles) into stocks (or seeds), and hope they will regrow next year. We still need to do this to get back to our original 60% Stock / 40% Bond portfolio, but more of our stocks (cucumbers) spoiled than should have if we were in balance after the initial growth.
If we do this rebalancing act enough over the course of our life, we can continue to harvest when needed, and avoid putting any excess portion of our money at more risk than it needs to be.
As you can see in the same graphic we covered last week, when we invest in a well-diversified portfolio, we do this with several different asset classes.
The farming equivalent would be to not only farm one type of crop, but several different crops that won’t all be impacted by the same type of bad weather, disease, or critters who may come and eat up what we are trying to grow.
Plus, would you really only want to eat cucumbers and pickles for your whole life? I wouldn’t.
Rebalancing isn’t just important to lock in gains, but as you can see from the first example, it helps us keep the risk at our desired level. While seeing more account growth can be a pleasant surprise, if we become too far out of alignment, the bad news can be equally devastating.
Simply put, when we rebalance, we are selling off the pieces of our portfolio that just won, and are buying into the pieces that just lost. “Buy low, sell high”.
If you go back to the chart with all the different asset classes, you will see that losers typically will become winners again over time.
It all comes back to having a system in place, managing your risk and allocation on a scheduled basis to avoid trying to time the market. The scheduled time allows the emotion of decisions to be removed, and avoid the hysteria sometimes created by the media that influences behavior.
I love this data, which displays the behavior gap of everyday investors versus the benchmark (buy and hold strategy). As you can see below, being able to stay the course in choppy markets, and maintaining the balance can have a huge impact over time.
Being in alignment is one core aspect we must be aware of when managing our investments over a long time period. Things are going to change, and your appetite for risk may change over time as well.
This can create even more opportunities for investors to try and make changes when they feel unsettled due to taking on more risk than they can stomach, and even further widen the behavior gap when we try to cut losses after a major drawback in the market.
Speaking of change, come back next week when we dive into what tax implications we should be aware of when making changes or contributions to our investments. Just as we spoke about this week, having a balance of differently taxed assets can help us navigate the ever-changing landscape of our life.
We will cover the basics and also dig a bit more into how much of an emphasis we should put on taxes as we go through the process of managing investments.
This week’s conversation will be an important one to remember when we cover next week’s material.
If this week’s material has you wondering what your advisor is really doing for you, feel free to schedule a meeting with me at the button below. Whether it makes sense to work with you or not, I would love to help you on your way.
See you right here next week!