I read an email from a long time reader, Gerald, here at My Dollar Plan on two posts that were recently published. They are Why You Aren’t Earning What Your Mutual Fund Says You Are, in which I wrote that the average investor earns a much lower return than the market due to the fact that the average investor jumps in and out of funds as well as the market chasing returns. The second post is Madison’s 2012 Asset Allocation Update where she went into detail about rebalancing and shifting her investments from an 88/12 portfolio to a 70/30 portfolio.
From the Mailbag
Gerald was wondering if the two posts contradicted each other. The simple answer is no, the posts don’t contradict, but I can see where there could be some confusion. Gerald also asked:
I was always wondering which one was better re-allocating funds every year or leave in the fund and let it ride?
Stay Invested for the Long Term
The point of my post was that the average investor, even though they are investing for the long term, tends to chase returns. They do this by buying a mutual fund and holding it for a few months, not getting the return they want and selling out and buying another fund. Additionally, they will pull out of the market and “sit on the sidelines” with cash when the market is dropping or is overly volatile and then enter back in when things calm down. The problem with this is that they are missing out on days when the market rises.
Because of all of that moving between funds and in and out of the market, the average investor earns much less than they could if they would simply buy into a few low cost index funds and ride the market.
Rebalance Your Portfolio
Madison’s post on the other hand is something that should be done, but many investors do not do: rebalance their portfolios. Rebalancing involves looking at your investment allocation plan and making sure that your current allocation matches that plan. If it does not, then you need to sell some funds where you are overweight and buy into funds where you are underweight. In other words, it forces you to buy low and sell high since the overweight funds most likely outperformed the market while the underweight funds underperformed the market.
Ideally, you want to rebalance your portfolio twice per year, and as long as the allocations deviate from your plan by 5% or more. Rebalancing when your allocation is out of line by less than 5% is not really worth it.
Additionally, as you grow older or have changes to your life, you may need to do more than a simple rebalancing of your portfolio. This is more closely to what Madison did. Her old plan had her at 88% stocks and 12% bonds. She realized this was too risky for her, given her circumstances and dialed it down to a 70% stocks/ 30% bond portfolio. Her ultimate goal is to get to a 60%/ 40% allocation.
Realize that she is not jumping in and out of the market or moving around from fund to fund on a regular basis. She is re-allocating her portfolio once and is sticking with what she has.
Hopefully this clears up any confusion there was between these two posts. If anyone has any more questions, or needs me to clarify anything further, please reach out to us here at My Dollar Plan.