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Say the value of your portfolio dropped 10% today, how would that affect your plans? Would you have to postpone retirement? Would you have to downsize your lifestyle? What about 20% or 30% or 50%?
How you answer that question should determine how much of your money you invest in stocks and how much you keep in cash. But there's a huge disconnect between how a lot of us answer that question and how we actually invest.
A lot of people -- and not just everyday people, but financial pros, too -- unintentionally invest like daredevils based on the belief that they've got the right stocks/cash mix. It's only after tripping on the high-wire that they realize there's no safety net below ... that their portfolios weren't actually as diversified as they assumed.
The reason for this devastating diversification mistake is surprisingly simple: failing to factor one's entire empire (no matter how small) into the asset allocation equation.
Have you spread out your risk? Have you really?
The mix of small U.S. stocks, large international stocks, bonds, and emerging markets in your 401(k) might be a textbook-perfect pie chart of diversification. But if you've also got a Roth IRA, some old bonds in your desk drawer, equity in your home, an old 401(k) (or four), there's a good chance that your portfolio is out of whack.
Having a diversified portfolio means allocating all of your assets across a bunch of investments that don't always move in the same direction. In other words, diversifying within your 401(k) alone is not proper asset allocation, unless your 401(k) is your only investment account.
If you haven't included all of your valuables in your plan, then it's time to rebalance your portfolio.
How many eggs should I put in what basket?
Before we get to the mechanics of rebalancing your portfolio, you need to decide exactly how you want your assets weighted. That's where the gut-check question from the beginning of this article comes in.
So how would you fill in the blank? "I can tolerate losing X% of my portfolio in the course of earning higher returns." In The Intelligent Asset Allocator, author William Bernstein translates that answer into a practical asset allocation strategy. He says, for example, if a 20% decline in your portfolio would send you reeling, then 50% or less of your money should be in stocks. (See the full chart in "Risk Drives Return." And for more on determining the proper mix of assets within your portfolio, see "Pick a Portfolio.")
Review your current holdings -- remember, all of your investments -- to see what percentage of your assets is invested in equities. If you need to make adjustments, dialing your exposure to stocks up or down, then there are several easy ways to do so.
The mechanics of rebalancing your portfolio
Rebalancing your portfolio simply means buying and selling investments to minimize your exposure to risk. The concept is simple, but the execution can get complicated, particularly if you have multiple investment accounts (Roth and traditional IRAs, old 401(k)s, current 403(b)s, etc.).
At The Motley Fool, we're believers in four main rebalancing strategies:
The add-and-subtract strategy: The easiest way to rebalance is to do the dirty work when you invest new money or make a withdrawal. For example, if you have mostly domestic large-cap stocks in your portfolio, you might invest in some international funds or stocks with your next IRA contribution check. Doing just that may not be enough to fully rebalance your portfolio, however. If that's the case, also use one of the following strategies.
The mothership strategy: If you have one account that contains the majority of your assets, lucky you: Concentrate on rebalancing in that account, particularly if it's a tax-advantaged account that doesn't charge commissions (e.g., an IRA invested in no-load mutual funds). Any smaller accounts that are outside your big kahuna "mothership" savings can stay invested as is.
The every-portfolio-is-an-island strategy: If you have several accounts that are of approximately equal value, treat each account as an individual portfolio. That means moving around the money within those accounts so that each portfolio has roughly the same mix of assets. To avoid getting sideswiped by fees, pay attention to the account's tax status.
The U.S.-large-caps-in-every-pot strategy: Chances are that U.S. large-cap stocks make up the biggest piece of your portfolio (as is the case with most investors). Given their size and volatility, this single asset class tends to grow or shrink way beyond its original allocation. If you've got many accounts, holding a position in large-cap U.S. stocks in each makes it easy to increase or decrease your exposure. Because they tend to be tax-efficient, they can also be one of the cheapest ways to right your ship.
More on managing your money:
It's a good idea to review your mix of investments at least once a year. For more allocation advice that'll help you sleep better at night, see:
Dayana Yochim's portfolio is diversified but her wardrobe is admittedly overexposed to the black-brown-gray palette. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.