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Ask the Advisor: Asset Allocation & Portfolio Rebalancing

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People like a winner. They also like a sure thing. That is why so many private investors saving for retirement leave their money in the same investments that were last year’s strong players.

It makes sense. It can also be a really big mistake, according Gregory Friedman, a certified financial planner and CEO and president of Private Ocean in San Rafael and Walnut Creek, Calif. He calls it investor greed.

“The desire to always go to last year’s winners is so strong and so consistent.  it’s like a siren’s call,” Friedman said. But investments, like the market itself, rise and fall. The key is to make investment decisions – your “asset allocations” – based on a long-term strategy; and to frequently “rebalance” where you put your money in order to compensate for those peaks and valleys. If you do both right, you should come out a winner when it comes time to live off those earnings.

Q: We hear the terms asset allocation and portfolio rebalancing used together. What is meant by each, and how do the terms relate?

Friedman: I think of asset allocation as the strategic setting of what assets, and then what percentages you want those assets to represent that will be included in a portfolio. Portfolio rebalancing is different. That is the systematic or periodic return of the asset allocation to the targets or the percentages originally set. One is setting them and what can be included in them and the other is how you get back to them. Markets move and you move off those targets fairly quickly.

Q: What is the goal with an asset allocation strategy?

Friedman: Simply stated, the goal of an asset allocation strategy is to get a desired return with the minimum risk, and that return that you are trying to get can absolutely be determined by an individual’s personal financial planning circumstances.

Q: What are the elements of an asset allocation strategy?

Friedman: Its determining what asset classes to include – which are appropriate and which ones do you want to include; what is the desired and/or required rate of return; what is the individual’s risk tolerance; what is their risk capacity (which is something I’ll define later); what is their income tax situation; and beyond that, what individual investment vehicles will be used to represent those various asset classes.

Q: You just used the terms risk tolerance and risk capacity. Please explain what those are?

Friedman: Risk tolerance is really the ability for an investor to emotionally “stay on their feet”, so-to-speak. As your portfolio fluctuates or as an investment fluctuates it’s the ability not to panic or abandon their investment strategy. Risk capacity is really more of a financial planning concept: what is your capacity to absorb risk from a financial perspective.

Said another way, if I am infinitely wealthy and my lifestyle expenses are very small, my financial risk capacity is very high. I can afford to take huge risks with my investments because no matter what happens, I’m good. To contrast that, other people spend a great deal, they demand a lot from their existing resources, and they withdraw quite a bit from their portfolio – their risk capacity is quite low. They really can’t afford to take huge risks because it would mean a certain change in lifestyle.

Q: What are the goals with diversification?

Friedman: Very simple; to manage risk. In a perfect world, with perfect foresight, no one would diversify. What you would do is say,’ I know that next year, within the next 12 months, small cap equities are going to do the best.’ So you put all your money there. In an uncertain world — and frankly in an unpredictable world — the goal of diversification is to put two or more – preferably more – investments together that over the long term (3, 5, 10 years) you expect will all make money, though over short periods of time they may not make money at the same time. The advantage is that something in your portfolio is always working.

One of the things I tell clients about diversification is that if we’re doing this right, they’re always unhappy. What does that mean? Because every time I show you a statement you’re going to run down the right side of all your investments, look at the returns, and you’re going to point to the ones with the high returns and say, ‘Why didn’t we have more of that?’ And you’re going to look at something that is down or didn’t make very much and say, ‘Why do we own that?’

Six months later we’re going to do the same thing, except the investments are going to be flipped. Whatever was the winner last time may not be the winner this time. So inevitably you’re always unhappy. But over time you’re actually getting where you want to go and you’re doing it in a lower risk way.

Q: What are the pitfalls and the dangers of an asset allocation strategy – things to be aware of?

Friedman: One I kind of referenced, but really it is investor greed. The desire and draw to always go to last year’s winners is so strong and so consistent – like a siren’s song – and it always feels like you can predict exactly what is going to do great. The pitfalls are sticking with it, really. Asset allocation is not a short term strategy. But it is a great long term strategy.

Q: How about portfolio rebalancing. What exactly does that involve and how to you know when it’s time to rebalance?

Friedman: The rebalancing is simply making sure that the asset allocation that you have put in play stays somewhat intact. Over time—just the way markets move, and also the fact that different assets have different expected returns over a long period of time—your allocations start to get out of whack and to drift.

For example, if equities tend to earn more and fixed income tend to earn less, but you have a 60-40 balance, by definition that’s going to go to a 70-30, 80-20, 90-10 split over a long period of time, very simply because the expected return on equities are higher than the expected return on bonds. Rebalancing is simply putting it back to 60-40 split. It’s really just keeping things intact.

Q: How frequently should you be examining your portfolio for doing a reset?

Friedman: There has been a lot of research on this, even down to ‘Boy, should we rebalance every day; every week; every month?’ And we’ve done a lot of research on this too. Just from a very practical standpoint, we rebalance once a year, and there’s no magic in that.

Ironically one of the things about asset allocation and rebalancing that is so interesting  — if you’re at a cocktail party and you ask an investor ‘How do you make money’, they’ll tell you buy low and sell high. That’s right out of investing 101. And then you look how individual investors behave and what they do: they buy high and sell low. What asset allocation with rebalancing forces you to do is buy lower and sell higher. You may not hit the peak and you may not hit the troth, but you’re consistently buying things that are more out of favor than not, and you’re consistently selling things as they are reaching highs. So what you’re doing is buying low and selling high. And it’s the hardest thing in the world to do because your emotions tell you to do it differently.