Happy New Year. It’s great to have you back.

We enjoyed a nice couple of weeks off work staying at the house doing a heap of work, including painting the garage, getting a good chunk of the house painted, completing most of the underfloor insulation, and clearing the weeds. It feels good to get so many big jobs done around the place that we struggle to find time for duing the year. Any time not working on the house was some good quality time spent with family and eating too much food. I have spent more time with my two kids in the last couple of weeks than I have for the last couple of months. My back also feels much better just for not sitting down in an office for extended periods too. It’s been fantastic and I would love more of it. Of course, that is what I am working towards in the near term. We also spent time binge watching Yellowstone.

I hope you are all well rested and ready for another year of self improvement.

Probably the greatest impact to managing your investment risk is making sure that you have the correct asset allocation.

So, back to basics.

What is asset allocation?

That is your percentage allocation towards different assets. For example, 20% bonds, 5% cash, 70% stocks, and 5% gold.

You can even break up your allocation within each asset class. For example, within your stock allocation you may also want to allocate 75% to a world fund, 15% to a NZ fund, and 10% to an emerging markets fund as one example. Or within bonds, you may want 50% government and 50% corporate.

If you want to take a punt on some individual companies, you can even have an asset allocation based on investing style. Such as 90% passive investing and 10% active investing (stock picking).

The best time to set your desired asset allocation is at times when the market is relatively calm. When the market is booming or crashing you are likely to make emotionally based allocations, not rationally based.

How to decide on an asset allocation?

It depends on a few factors, namely:

• Your time horizon;

• Your tolerance for risk;

• Your goals
  

Basically, you are trying to determine what goals you need to finance and when you need to finance them by. For financial goals less than 5 years away, you won’t want to hold many stocks. For financial goals over 10 years away, you may want to hold nearly all stocks. This is not a recommendation; this is just a numerical example of what someone may want.

I have seen people recently saving for a house deposit in the next couple of years investing in stocks. Now this is not my preference for investing as it tends to ignore the time horizon part of the equation. There is a very real likelihood that your stocks will go down in value, leaving you worse off over such a short time horizon. But for some people, the risk is worth the reward. That is where the tolerance for risk comes in. That is different for everyone.

The importance of rebalancing your portfolio

Now that you know the basics of asset allocation, we will go over rebalancing. This is the process where you put in steps to prevent your asset allocation from drifting.

The best way to explain is by using an example.

Todd sets a desired allocation of 70% stocks and 30% bonds. He invests $1,500 a month for four years. $1,050 to stocks and $450 to bonds. Over that period stocks have returned 15% real returns a year and bonds have returned 4% a year. At the end of four years, Todd’s investment balance is $69,345 in stocks and $21,670 in bonds. That translates to 76% in stocks and 24% in bonds. Quite a lot more aggressive than your original intentions. Extended over longer than 4 years or with a larger differential in returns between different asset classes and this number can drift even further. Now taking on either too much risk or too little risk.

The key to investing is taking on the maximum amount of risk you can based on your goals, but not more or less. Rebalancing is what helps you to achieve this, and once per year is generally fine.

To rebalance, you just sell from the asset class that has outperformed and buy more of the asset class that has not performed as well.

To help with this I have recently added a rebalancing spreadsheet to the website, that you can access.

Hopefully it can help you remain optimally invested.

If you need an investment plan or recommendations , then get in touch today.

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here