Looking at how stock indices grew throughout 2017 (the Dow Jones Industrial Average rose to 23,000 points by mid-October and then broke above 26,500 points in January 2017), it might seem that this record bull market has no foreseeable end. However, despite the high performance, investors calmly withdraw money from stocks during 2017..
Although it seems illogical – to sell shares during the growth period, investors were right, as early as February 2018, the index collapsed by 1,500 points in a few days.
Source: tra.viewview.com, the price of the DJI index on the chart is indicated at the time of publication of the article.
Some people cashed assets, while others transferred them to bonds. This is partly reasonable and necessary to reduce risk, as annual profits can easily be destroyed by stock market crash.
About the reasons for the decline of the Dow Jones index read our article: How technology excited the stock market
Balancing and redistributing investments
Asset redistribution is a basic principle of long-term investment strategies and a useful tool for achieving goals.
The idea of redistribution is to first set a goal based on risk tolerance. That is, the ratio of money in stocks to money in bonds. Aggressive investment portfolio can consist of 90% of shares and 10% of bonds, and conservative – by 60% and 40%, respectively. Then you periodically check the portfolio and adjust the current ratio in accordance with the indicated percentages. That is, if stocks grow and go abroad in 60% of assets, they must be converted into bonds.
Stocks rise faster than bonds.
Most likely, in 2018 you will have a higher percentage of money in stocks than originally planned if you did not redistribute the investment earlier. Money never balances on its own.
Despite the fact that there are many recommendations for redistributing assets, the basic principle is: we want to keep more money in stocks at the beginning of a career and less closer to retirement. In any case, this is a matter of choice. As Colin Jaconetti, senior investment strategist at Vanguard, said in an interview: “Everyone decides for himself”.
To better understand balancing, we present you with a guide on how it works, why people do it, and how to develop the most effective approach..
Why should I redistribute assets?
William Bernstein, financial theorist, neurologist and author of The Four Pillars of Investing, said: “Redistributing investments is more necessary to control risk than to increase profit”.
Of course, if you want to get the most out of your money in the long run, you are likely to invest 100% of your money in stocks, not bonds. However, the problem with this approach is that stock prices fluctuate much more strongly. They can jump to a historic maximum of 54%, and then fall by 44% in one year. On such a roller coaster, a rare investor will not get upset. Fear of losing capital can drive you out of the market at the most inopportune moment, and you will lose more money than with a pre-thought redistribution of investments.
Bond portfolios on an annualized basis since 1926 have grown by only 5.4% compared with 9.7% for stocks (see chart). However, those who invested in stocks were forced to endure strong price fluctuations in each year in exchange for higher returns..
Source: investor.vanguard.com. Calculations based on FactSet data. Past performance does not guarantee future earnings.
Stock prices are more volatile, but also give higher returns over time (according to Vanguard).
When balancing, you stick to a combination of investments that is aggressive enough to grow wealth and does not jeopardize the entire plan. Jaconetti also said this: “An investor whose portfolio consists of 100% shares is forced to leave the market if it falls by 40%”.
This is what some people did in 2008, when the stock market collapsed by 37%. At the peak of the financial crisis, investors withdrew $ 43.3 billion from mutual funds in one week. It is a sad fact, but the one who cashed out his investments in 2008 missed the opportunity to win back losses during the double-digit growth of the market in 2009.
How investment redistribution works?
To illustrate how redistribution works in your favor, we give an example with a portfolio of $ 100,000, which consists of 60% of shares and 40% of bonds. Countdown – 1997.
If you carry out balancing in accordance with the 60/40 rule every year, then by the end of 2016 you would have increased your funds to $ 377,510. If there were no balancing (left columns), you would have received an income of $ 28,490 less, as the following diagram shows..
Redistributing your investment portfolio brings more money in the long run. In this example, a balanced portfolio has lost less value on downturns and has surpassed an unbalanced portfolio with an equal initial amount..
Redistributing investments is relatively rare to be able to bring you significant profit for a single year. However, let us recall Bernstein: “How well you manage long-term investments is not related and not proportional to how confident you are in rare but severe market downturns. Investing is an operation that gives wealth to those who have a strategy and who are ready to adhere to it, unlike those who cannot or do not want to do this. ”.
What risk are you willing to take?
One of the first questions that you need to ask yourself before trying to redistribute available funds is: “What proportion of money do you want to invest in stocks against bonds?”.
Quite typical is the distribution from 70% to 90% in favor of shares, if your age is 20-30 years. The closer you get to retirement, the less risky your portfolio becomes. The share of shares in it is reduced in the direction of 40-60%.
It is necessary to calculate the correct ratio of stocks to bonds taking into account your risk tolerance.
1. What is my risk appetite on a scale of 0 to 10?
2. Will my financial situation be in order if my portfolio falls by 50% in a year?
3. How stable is my main source of income?
4. I prefer investments with little or no variation in value.?
The basic disadvantage of such questions is that they consider hypothetical situations. In reality, “There is only one way to calibrate your risk tolerance – to test it in real conditions,” says W. Bernstein. You cannot know exactly what you will do in a falling market until you feel real discomfort from a 25-30% drop in net worth. It really hurts.
Moreover, the current state of a person can also be misleading. Bill Van Sant, financial planner and managing director of Univest Wealth Management, said: “People are more aggressive when the market grows, but in a recession, like in 2008, they get scared.” Control your emotions in any of these cases..
To circumvent this problem, W. Bernstein suggested applying periodic redistribution of investments to determine the true risk tolerance. On this occasion, he said the following: “For example, if you hold a portfolio of 60 to 40 (stocks / bonds) and you feel insecure in a recession, this is too aggressive a ratio for you. On the other hand, if such situations do not cause you discomfort, you can think about increasing profitability by investing money in stocks..