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Set asset allocation is one of the major schools of thought regarding portfolio management and is used by many financial advisors and individual investors. For those committed to annually rebalancing their portfolio January is a common time of the year to reallocate funds according to the allocation previously made based upon risk levels financial goals and objectives. Asset reallocation naturally forces you to buy more when an asset’s price has gone down. Let’s look at a typical asset allocation model for a portfolio totaling $1 000 000:
- Stocks 50% $500 000
- Bonds 25% $250 000
- Cash 25% $250 000
If the above amounts were in your portfolio as of last January and you rebalance each January the amounts would unfortunately look something like this for January 2009:
- Stocks $350 000
- Bonds $200 000
- Cash $257 000
This is assuming that your stock portfolio went down 30% bonds decreased 20% and your cash earned a small amount of interest. The bond fluctuation amount would have varied depending on the type of bonds in which you were invested. In order to return to the original asset allocation model you chose in a previous year your new asset allocation would look like this based on the total value of your portfolio now being $807 000 and using the original percentage for each category:
- Stocks 50% $403 500
- Bonds 25% $201 750
- Cash 25% $201 750
As you can see set asset allocation models force you to buy assets when they have gone down in price and sell assets when they have increased in price. In this example you would have purchased an additional $53 500 in stocks at the current deeply discounted values. Many stocks are now paying decent dividend yields which would enhance the stock portion of the portfolio even more. Another major advantage of a strictly adhered to asset allocation model is that it removes the emotions of investing and thereby significantly decreases the likelihood of buying high and selling low. Additionally the annual rebalancing which should be done after one year and a day to generate long term capital gains vs. short term capital gains is tax favorable due to the current lower long term capital gains rate. The downside of a set annual asset allocation is that the investor may miss the rest of a trend that could carry on for several years. This of course could be good or bad depending on whether the market is going up or down for each asset class. The topics presented above are covered in depth in our Investing 101 course.