After you make your initial allocation
, you want to monitor its investment performance
over time. A good place to start is to calculate the portfolio's weighted-average
rate of return.
For example, let's assume your initial allocation of $50,000 exactly a year ago was 70% in stocks, 20% in bonds and 10% in cash.
The following table shows that stocks earned a 10% rate of return for the year, while bonds earned a 7.5% return and cash earned a 5.5% return. Based on these returns, and assuming no reinvestment
of dividends or interest, your portfolio's current value
To calculate the weighted-average rate of return for the portfolio, multiply the return for each asset class by its original weighting. Then add the returns. In this case, the weighted-average return is 9.1%: (.10 x 5.5)+(.20 x 7.5)+(.70 x 10.0). You can check this by calculating the percentage change in the portfolio value: ($54,525 - $50,000) / $50,000 = 9.1%.
The portfolio's current weighting is only slightly different from its original weighting: Stocks now make up 70.6% of the portfolio value, while bonds comprise 19.7% and cash comprises 9.7%.
Since your allocation has only slightly changed, you may not need to rebalance
. But consider another example. You start with the same $50,000 portfolio and the same allocation. In this case, stocks earn a 20% rate of return over the next year, while bonds and cash each earn a 5% return.
The weighted-average return has risen to 15.5%. Notice the change in weightings -- Stocks now make up 72.7% of the portfolio. You may decide to rebalance to the initial allocation, which would require shifting 2.7% of the current value of stocks -- or $1,575 -- into bonds and cash.
As in this case, rebalancing is often an exercise in fine-tuning your current allocation. No drastic revisions should be necessary if you've set up your initial allocation
properly. Even with single-year returns of 20% for stocks, which the previous case assumed, the amount to rebalance was only $1,575 for a portfolio worth almost $58,000.
Financial experts suggest you rebalance once a year or so, gradually shifting towards a more conservative allocation as you get into your 50s and 60s. Some major reasons to rebalance include:
A change in your investment profile.
Your investment profile
is a composite sketch made up of your financial goals, risk tolerance and investment horizon. Your investment profile changes if any of these elements change. Typically, investors increase their allocations to cash and bonds
as they get older.
Changes in relative investment performance of assets. Although stocks outperform bonds over the long term, there are periods where bonds outperform stocks.
A major life event. Major life events such as the birth of a child or unexpected medical expenses will likely lead you to change your investment profile. As a result, your asset allocation needs may change.
Failure to reach financial goals.
You may need to rebalance in favor of aggressive-growth or growth stocks if you fall short of your financial goals
. There are many reasons for falling short, including overly optimistic expected returns
, unanticipated inflation
or a change in your savings contributions
This information should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Updated: January 2004