It is not uncommon for financial advisers to remind investors about the importance of portfolio diversification. Even the most carefully composed investment portfolios can get out of balance from time to time.
To make sure a portfolio stays on track to reach desired goals, it's important to take the time regularly to rebalance and make sure the portfolio's investments are still in line with investors' objectives.
Some of the most common reasons a portfolio could get out of balance would involve a change in the ratio of the asset classes - the general types of investments that make up an overall investment mix - or a change in the value of various assets. Asset classes include stocks, bonds, cash, mutual funds and exchange-traded funds. As the respective values of those various investments change, the proportions in a portfolio will change as well.
That's why it's important to check in on investments regularly and make sure the division of assets doesn't stray too far from the desired allocation.
To illustrate, let's consider a very basic portfolio made up of stocks, bonds and cash.
Out of these three asset classes, stocks are likely to see the biggest price fluctuations.
If the price of the stock position rises significantly, the overall percentage of stocks in the portfolio grows and the percentage of cash and bonds decreases.
An imbalance may increase portfolio volatility as a greater percentage of assets face a higher level of risk, particularly due to the fact that stocks tend to carry more risk. At the other end of the spectrum, if stock prices drop, the percentage of equity assets in the portfolio decreases as well. The risk is lowered, but so is the opportunity for growth.
Another way to look at the issue is to consider a hypothetical example with numbers.
Suppose that $10,000 is invested in bonds and $10,000 is invested in stocks at the beginning of the year. By year's end, the stake in bonds has grown to $10,475 (for an annual return of 4.75 percent) while stock holdings are now worth $11,560 (a 15.6 percent return).
While that's a nice overall return for a portfolio, notice that the investment mix in stocks and bonds has strayed from the 50-50 split at the beginning of the year. At this point, the portfolio is 52.5 percent stocks and 47.5 percent bonds, and at this pace, the difference could get much bigger in just a few more years.
Rebalancing helps put the portfolio back in line with the original allocation.
Note that this example is for illustrative purposes only and doesn't reflect the performance of any specific investment.
When a portfolio gets out of balance, it's important for investors to realign their holdings by making adjustments in accordance with their long-term strategies. Meeting regularly with a financial adviser to discuss your asset allocation enables investors to spot significant changes and make the necessary adjustments to get portfolios back on track. [[In-content Ad]]
Joe Froehle is vice president-investments with Wells Fargo Advisors LLC, member SIPC, in Springfield. He may be reached at joseph.froehle@wfadvisors.com.
