It's easy to set and forget the asset allocations of your retirement portfolio. But your nest egg needs to be rebalanced regularly, at least once a year, to ensure it's on the right track to providing optimal returns and adequate safety from risk.
What is asset allocation?
Let's review what assets in a retirement portfolio should do to grow into a comfortable retirement nest egg that will support you well into your later years.
A strong retirement portfolio needs two central elements:
- The first is the potential for reward, or upside: gains in stock prices, dividend payments, and interest paid, to name a few.
- The second is safety, or protection against risk: stable investments that will return money year in and year out, with minimal exposure to downturns.
Asset allocation is a way of ensuring you have both elements: reward potential and protection from risk.
Generally speaking, the stock market has the greatest potential to maximize reward. Over time, the U.S. stock market has returned 7% annually, on average. That's not to say it hasn't had down years -- it certainly has. But bear markets (those down 20% or more) have reliably been followed by prolonged bull markets that make up the losses and more.
Plus, inflation rises at an average of over 3% annually, so investors need to factor the effect of inflation into their investment choices. Stocks are one of the few investment classes that has reliably outpaced inflation over time, so by investing in stocks, your money grows faster than the prices of goods and services are increasing.
But, of course, investors also need downside protection from bear markets, or insulation from the underperformance of a particular stock. That's where fixed-income investments shine.
Fixed-income investments include bonds and bank Certificates of Deposit (CDs). These assets return less on your investment than stocks do; you can expect 2.5% and 3% in yield from bank CDs right now. But the yields can be safely locked in for certain periods of time, so part of your retirement funds become recession-proofed. In other words, the increase in value may be more modest than stocks, but also is likely to be steadier and safer.
While there's no law governing how you balance these two elements, there is a good rule of thumb for determining how to allocate the two asset classes of stocks and fixed income in your retirement portfolio: subtract your age from 110 and place the remainder into stocks, and the rest into fixed-income investments. These intended proportions change over time as your stocks grow, your winners run and your positions change. For this reason, and others, you need to rebalance your retirement funds at least once a year.
1. Stock market fluctuations can change the balance of your assets
The first reason is that stock market fluctuations can change the asset allocation you've set up. If the stock market has a strong bull run in the year, it can result in your portfolio evolving in a way that its percentage allocated in stocks becomes outsized.
Let's say you have a portfolio worth $10,000 in total and you're 40 now, so using the subtract from 110 rule, your goal allocation is 70/30: You have $7,000 in stocks and $3,000 in a CD. If the stock market rises 25%, as the Dow Jones Industrial Average did in 2017, you'd end up with $8,750 in stocks. Your CD may have yielded just 0.5% in 2017, so you gained $15 on the year in that portion of your portfolio. (Interest rates have risen since then.) So your entire portfolio is now worth $11,765. The 70% target you want in bonds is $8,235, so you'd need to adjust the $8,750 downward to that level to retain your proper asset allocation.
And this is just one year. In long bull markets, failing to rebalance regularly can mean that you become highly overinvested in stocks relative to your age, which can leave you vulnerable to risk should a broad downturn occur.
And these market downturns are another argument for regular rebalancing. If you have the same $10,000 portfolio, at a 70/30 allocation and the stock market drops 15% in a year, you'd end the year with $5,950 in stocks rather than $7,000. At that point, you may be underweighted in stocks, and you may need to rebalance your asset mix again.
2. Fixed-income investments need to be adjusted to maximize your return
Fixed-income investments need to be rebalanced for several reasons. First, reinvested interest can change the allocation of your portfolio over time, and you need to adjust it if it has.
Second, interest rates change. If they've risen, take advantage by purchasing higher-interest rate instruments, if possible. Higher interest rates give you a greater return on your investments. (It may not be possible if you've purchased a long-term CD or bond; be sure to check the forecast direction of interest rates before you purchase any kind of fixed-income investment. It's not advantageous to lock yourself into an interest rate if they are expected to climb soon.) If they've dropped, you might want to shop around to snag the highest yield available.
Third, while bond prices do not change to the degree that stock prices can, they do fluctuate. Generally, they move inversely with interest rates. If interest rates rise, bond prices will fall; when interest rates drop, bond prices climb. Adjust your portfolio to retain your asset allocation given any changes in bond prices.
3. You need to change your asset allocation as you age
The 110 rule of thumb illustrates that your asset allocation should change with your age. The beauty of this plan is that it ensures that portfolios become less risky the older you become, while still retaining your ability to benefit from stocks. That's the final reason you need to rebalance your portfolio every year.
If you're 40 and there's a bear market, your portfolio has 25-plus years to recoup any losses. If you're 65, though, the hit to your retirement nest egg can impair your ability to live comfortably tomorrow. You want less risk in your portfolio as you age, because you have fewer years to bounce back from a stock market downturn and you're closer to needing to live on those precious savings.
Don't neglect to tend to these pesky proportions, and make sure your asset allocation is opportune for your age, at least once annually.