For starters, I’m assuming a couple things as I write this article about rebalancing a portfolio:
- First, I assume your portfolio is comprised of more than a single “all in one” fund.
- Second, I assume that different growth rates will cause one sector, or type of investment to represent an unintended proportion of your portfolio at some point.
For starters, let’s loosely define what it means to have an unbalanced portfolio. An unbalanced portfolio refers to at least one component of a portfolio that is overrepresented. Simply put, it’s too much of one thing.
Any time a sector in your portfolio surges, that’s great news. Let’s say the energy market jumps up 25% in a short period of time. Many of us would be tempted to pour more money into that well-performing chunk of our portfolios.
This can be dangerous.
Before you know it, you can have a third of your young portfolio invested in something that you never intended to bet your future on so heavily. Keeping your portfolio in balanced harmony requires discipline. It also requires a willingness to ignore short-term market trends and sudden surges that can tempt you to create a portfolio imbalance as you seek an immediate payoff.
If the concept of rebalancing your portfolio is new to you, consider the following metaphor:
Roughly 15 years ago, my employer was a thriving competitor in its industry. Many attributed this success to its large collection of highly experienced employees who were well-prepared to assume advanced roles throughout the company.
The company had longer tenured employees than most of its industry competitors. However, their employees were on average about six years older than the industry mean.
After years of success, employees began to retire in bunches. The overrepresentation of older, more experienced employees eventually lead to rapid turnover as these skilled employees began leaving the company.
The company struggled to operate at the high level it had grown accustomed to as its overrepresentation of experienced employees left a gaping void. In fact, the company began to panic as it frantically searched for new and young sustainable talent.
My company learned from this experience and has turned to recent college graduates as a way to rebalance the company’s workforce. Retaining skilled, experienced employees is important but the company has also realized the importance of creating an even distribution of employees with all levels of experience throughout the company. This will help the company avoid huge openings in any particular area of the organization and keeps the company well equipped to respond to any employment need that may arise.
Similar to the way my company poured so many resources into highly skilled, experienced, long-term employees at the expense of developing younger employees, you might be tempted to chase short-term successes even though it may result in a portfolio imbalance. But like my company, there will eventually be a price to pay for that strategy. What’s worse is that you’ll quickly see how easily you could have avoided that harmful volatility. Let’s not make that mistake.
My Real Life Example
I bought a Vanguard fund called the Total Stock Market Index Fund. Here’s how the fund allocates various sectors across the fund:
As I reviewed the fund allocation, it occurred to me that the real estate sector was underrepresented.
This is just my opinion, but I suspect that some index funds underrepresent real estate because they assume that the typical American with investments is also carrying a mortgage (which, depending on who you ask, means they have already made a considerable investment in real estate).
I currently rent and don’t have a mortgage. For that reason (among others), I decided that I should go outside of my index fund to allow real estate to represent closer to 15% of my portfolio, rather than 5-10%.
In case you’re wondering, here’s how I concluded that real estate makes up 5-10% of my portfolio.
Every sector that makes up your fund has sub-sectors that engage with one or more segments of the market. For instance, Mortgage REITs really represent both the real estate and financial sector, but are typically classified under the financial sector umbrella.
This type of classification is why many investors don’t understand exactly how their money is allocated in their funds.
By going through all the sub-sectors of my fund, I concluded that I needed to give real estate a larger role in my portfolio.
Examining fund sub-sectors is the get your hands dirty way of figuring out the composition of your portfolio. There are also snapshot tools that do the work for you.
I highly recommend doing the work yourself at first to gain a true understanding of what’s going on. Now that I understand what I’m looking for, I’ll use snapshot tools to save time since I usually just want a quick progress report.
I Gotta Have More Real Estate in My Portfolio
Once I determined that I wanted to increase the role real estate played in my overall investment portfolio, I began funding a Vanguard Real Estate Investment Trust (REIT). The REIT invests solely in real estate companies and carries a risk factor rating of 5 out of 5. Keep in mind, virtually any sector fund will carry a 5 out of 5 risk rating. Real estate is just one segment of my investment portfolio, so as long as it doesn’t represent more than 15% of my total portfolio, the risk rating doesn’t matter much to me.
The REIT I invested in soared. I saw 18% gains during the first two years I invested in the fund.
Of course, huge investment growth might not seem like much of a problem. And if we’re going to categorize it as a “problem,” it sure is a good one to have.
The thing is, I had automated my contributions to the REIT and was pumping way more money into it than I planned. After about a year I looked at my portfolio snapshot and was shocked to see that real estate represented 23% of my overall portfolio. That’s nearly a quarter of my investments being placed into one sliver of the market.
Though my portfolio had become lopsided, there was a simple solution.
First of all, I needed to halt my monthly contributions into the REIT. At the same time, I needed to continue funding my diversified index funds, energy funds, and health care funds, which had become underrepresented.
The second thing I needed to do was check my portfolio snapshot a little more often. Paying attention a little more often would help me achieve the balance I wanted in my portfolio.
Within eight months my portfolio was rebalanced to reflect my original investment plan.
REITs continued to perform well, but I still pushed my real estate investments back down to 15% of my portfolio. Despite missing out on continued growth in that sector, I understood that I needed to stick to my big picture plan. I’m investing for the long-run, not for a two year stretch during my 20s.
A Few Final Thoughts
The solution I described above might not necessarily work in every situation. For instance, if someone had a portfolio that had grown extremely lopsided from 10 years of misallocation of funds, it might be wise to speak with a financial professional about the best way redistribute your investments. In fact, that person’s portfolio might need a total makeover.
However, if you’ve only been investing for only five to ten years, then there’s a good chance that my DIY approach could get the job done.
The key to handling your own portfolio is to start by creating a plan. After that, trust your chosen allocation. Ignore short-term surges that occur in individual segments. If your plan of allocation was sound three years ago, then don’t let one month of market activity blow up your carefully created plan.