Allworth Co-CEO Scott Hanson breaks down four of the biggest components that any comprehensive portfolio needs to take into consideration.
When it comes to investing, you hear a great deal about the importance of things like proper asset allocation, risk tolerance, time horizon, and automatic portfolio rebalancing, but what are they?
Asset allocation
First, asset allocation is a strategy that focuses on how your money is distributed among various investments, which includes stocks and bonds, but also cash.
You might see that, “…but also cash” and wonder, “How so?” For an example, when markets hit a downturn, some investors wonder if they should sell their equities and jump to cash.
Because cash is entirely “safe,” correct?
As we have all clearly seen with our record inflation over the last few years – but this is also true even during periods of low inflation – over time, cash loses purchasing power.
One thing we have been asked often in the last year, and it's not uncommon when the markets hit a rough stretch either, is, “Should I move to cash?”
But if you liquidate your investments and move to cash, you are not only going to lose considerable purchasing power over time due to inflation, but you are locking in those dreaded losses with the decline in the value of your stocks.
When it comes to the risks associated with an all-cash investment diet, an even simpler way to say it is that your cash is losing money if the rate of inflation exceeds the interest you are earning on your savings accounts. (Which is virtually a constant.)
That is why asset allocation is so important. And your asset allocation is going to be determined by your risk tolerance and your time horizon.
Risk tolerance
Your risk tolerance is the level of market volatility you are comfortable enduring as an investor. Can you comfortably tolerate risk, including the stress of normal fluctuations in the market – and even losses that, ideally, only occur over the short term – for the possibility of larger gains in the long term?
Identifying your tolerance for loss is one of the foundational aspects for determining the investment allocation your advisor will recommend for you. In part, your advisor does this by familiarizing his or herself with your overall financial situation, and then by helping you to identify your tolerances. In this way, a qualified, fiduciary advisor, helps keep an investor from making emotional or uninformed financial decisions about money.
It is one of the most important things an advisor does.
Time horizon
In financial terms, a time horizon is the duration that an investor intends to hold a particular investment until which time that they will need that money back. Time horizons are predicated on a person’s individual financial goals, but we most often associate them with retirement dates. (And yet, they can also be contingent on large purchases such as buying a new house.)
So, one of the primary ways in which a person’s risk tolerance and time horizon impact one another typically has to do with a person’s age. And that is, the closer a person gets to retirement, the shorter their time horizon (when they will need the money). And the shorter an individual’s time horizon, typically, the more conservative their investment risk tolerance becomes, and that is because there is less time left to work and save and recover from downturns in the market. (That is why it is so common for investors to “rein in” their risk tolerances as they get older.)
Automatic rebalancing
Automatic rebalancing is when your investments are adjusted to keep your money in alignment with your allocation elections and preferences.
But why does it need to happen?
Let us say you have saved well and are a fairly conservative investor who wants to retire in a few years, and so you and your advisor have selected a model portfolio that allocates $1,000,000 of your savings evenly between stocks and bonds. That is a 50/50 stock-to-bond allocation and that is what you are comfortable with.
But let us say that, for the sake of example, over a year, the markets rise to new highs, and outperform all expectations, and now your investment allocation (the money you have invested) is distributed 65% to stocks and 35% to bonds.
While the increase in the value of your stock allocation is certainly nice, your portfolio has moved away from its targeted mix, which, remember, was chosen partly based on your risk tolerance level. Now you are substantially over-exposed to stocks, while the bond portion of your portfolio – which may have grown in value, as well – is substantially underweight. (And note, that your investment allocation can stray from your ideal mix and balance and become under or overweight due to declines in your investments, as well.)
Automatic rebalancing is the systematic reallocation of your portfolio to bring your investment elections back in line with your risk tolerance and time horizon, and it is a key part of investment management. In short, it acts as a counterbalancing instrument, which, in a sense, is you “buying low and selling high,” and is but one key safeguard that helps protect you from the possibility of incurring a loss from which you might not have time to recover.
While there are of course many other factors, and while the above doesn’t take into consideration significant aspects of building a portfolio – such as how we measure a particular investment’s risk – allocation, tolerances, time horizons, and automatic rebalancing are but four integral mechanisms we braid together to help you reach your financial goals.