As the end of the year approaches, take a break from stressing about the holiday season by getting your personal finances in order. It’s a great time to finish your charitable contributions and adjust your 401(k) contribution. It’s also better to fund your IRA now than it is to wait until the April deadline. You can also use this time as an opportunity to adjust your investment portfolio.
Having a hands-off approach to investing is an acceptable strategy. Over the long term, a diversified portfolio of stocks has historically grown in value enough to build wealth, but only over long periods of time. Advisers, especially those who appreciate the low-cost advantages of using index funds rather than actively-managed mutual funds or stocks, have generally said to invest now and leave your investments alone without too much tampering.
Some tampering is required, though. Even if you like the set-it-and-forget-it approach to investing, each year you should evaluate your financial needs, goals, and risk tolerance to ensure you’re still invested in the most effective way. There are two goals when rebalancing your portfolio. First, if your underlying investment approach needs to change, you can reflect your new needs in how you distribute your investments between stocks, cash, and other asset classes. Also, rebalancing gives you the opportunity to lock in gains in one asset class while taking advantage of lower prices in another.
Evaluate your goals and needs against your reality
There are circumstances where your investing approach might need to change. If you’ve been investing 10% of your income every year in stocks and no other investments, you are accepting a certain level of risk. If one of your family members suddenly becomes ill and needs expensive care, you might find that you now have a larger chance of needing the money you’ve been saving for retirement in the near future. Suddenly, having your wealth tied into volatile assets is riskier than you can afford.
In another example, you might have inherited an investment. If this changes your financial situation, you may find that you no longer need an annual return of 8% to reach your financial goals. You could accept less risk and lower returns, and this could be reflected in your investment strategy by moving away from stocks into less volatile investments like bonds.
Look at your entire investable net worth
Your 401(k) plan might have an option to periodically automatically rebalance your portfolio based on your preferences. Rebalancing in general, whether automated or not, is a good way to lock in gains and take advantage of lower prices, particularly in a tax-efficient account where you don’t need to pay the government anything as a result of your gains. For example, in a basic scenario, you might have chosen to invest 60% of your portfolio in stocks and 40% of your portfolio in bonds. If stocks have a great year, they might have increased in value to represent 65% of your portfolio, leaving 35% for bonds. Without changing anything, you now have a riskier profile than you intended.
Rebalancing will allow you to sell the 5% of your portfolio, invested in stocks, and use the proceeds to buy more bonds, moving your profile back to 60% stocks and 40% bonds. You’re selling high and buying low, precisely the type of investing strategy that has a good probability of succeeding over the long term.
If you set your initial investment and risk profile with just your 401(k) in mind, you might not be considering outside investments like IRAs and taxable investment accounts. Take a holistic approach, looking at your entire investment portfolio, including how much cash — money market funds or savings accounts — you have. When rebalancing, you should take your entire financial picture into account. This is a reason automatic rebalancing options in 401(k) plans are not always sufficient.
Published or updated December 13, 2011.