Markets & Economy
Asset allocation and rebalancing
May 23, 2014
Rebecca Katz: Our second question—we actually had a question following up on asset allocation through Twitter. And this is from Moshak258, so thanks for the tweet. And he says, "How do you decide on a correct asset allocation?" So Chris we've had some discussions about perhaps some guideposts you could think about if you're doing this on your own and you don't have a benefit of a financial planner.
Chris Philips: Yeah. Something that is relatively easy, whether you're at Vanguard or some other financial provider out there in the industry, is there are a lot of what are called "target-date funds" that are out there. And target-date funds, or target retirement funds, are designed to change your asset allocation over time in conjunction with a proposed date that you think you might retire. Why that can be an effective tool or guidepost to think about what a reasonable allocation might be is that it can align with your age. And the age or the time horizon you have for this drawdown of money is one of the most, if not the most, important components to actually establishing that mixture of stocks, bonds, cash, or other assets if you would like that.
So I would say that a reasonable place to start looking might be what a target-date fund might be for you as an investor. There's also a lot of tools out there. There are risk questionnaires that a lot of financial services firms provide. And a risk questionnaire is a series of questions that you answer, and your score at the end will determine what your mixture of stocks, bonds, and cash might be based on, again, on your horizon, the amount of risk that you think that you are willing and able to take in a portfolio.
Rebecca Katz: Great. So we have two questions just in, and both are about our rebalancing conversation. So thanks for like minds here. Richard from California says, "Doesn't rebalancing often generate undesirable capital gains?" And then, IamtherealDaveB says, "Is there a point at which the tax consequences of rebalancing outweigh the benefits?" So, similar themes. What do you think? And of course in this case we're talking about outside of a 401(k) plan like I have, which is tax-free.
Kahlilah Dowe: I think that's an instance where going back to, Chris, what you said about using your 401(k) contributions as a means to rebalancing will help to alleviate some of that. I think, ideally, you need to rebalance. So I wouldn't want investors to avoid rebalancing altogether in an effort to avoid tax implications.
Rebecca Katz: And the tax implication is because you're selling some part of your portfolio and buying others, and the sale of your portfolio could generate taxes.
Kahlilah Dowe: Right. Because you're selling the investment that's had the better performance, and you're reinvesting into the asset class that's had the lower performance. And that could have some tax implications. But I think the flip side of that is that if you don't do it, you could take on risks that you never intended to take on, in which case that wouldn't work also. So I would say if taxes are really a concern, consider using your contributions as a way to rebalance the portfolio without having to sell shares.
Rebecca Katz: So put your new money into the lower-performing asset class?
Kahlilah Dowe: That's right. So moving new money into the lower-performing asset class, that may take a little bit more work. So if you have it set up so that 70%—or let's say 50% goes into stocks, 50% into bonds, you may need to make some adjustments there.
Chris Philips: The other way to think about it is to think about what some rules or some guardrails around that rebalancing strategy might be. So some of my peers have done a lot of work on rebalancing within the methodology of how we think about investing. And some of the conclusions that we've come to have been that rather than think about I need to do it semiannually or quarterly or annually, think about has my portfolio moved more than five percentage points away from what my targeted asset allocation actually is?
So if we start with a 50/50 allocation between stocks and bonds, and due to last year my stock allocation is now 57% and my bonds are now 43%, that might be a good rebalancing opportunity. But because we don't get too many years like last year, take it back down to that 5% threshold.
So you're not selling the full seven percentage points, you're selling 2%. So you're minimizing taxes; you're getting back to what a reasonable boundary might be for your allocation; and you're trying to balance that concern of risk mitigation through the rebalancing, the tax considerations, as well as the frequency of the rebalancing itself. So there are methodological ways to approach this that can balance those two components.
Rebecca Katz:. So our next question is from David in San Jose, California, who says, "What is the best approach and timing for rebalancing a portfolio?" You shared one approach about the 5% methodology. Is there something else that you frequently see with the investors that you serve, Kahlilah?
Kahlilah Dowe: We definitely use the 5% rule of thumb, because the market is going to go up and down and we want to leave room for that. The other thing is just more of a set time each year, so semiannually or annually. It's not always—it can be daunting for some of investors to do it semiannually. So I would say annually at the very least. And I know you had mentioned, Chris, the target retirement funds. They automatically rebalance as you contribute to it. So that's also an option, but I would say at least on the annual basis.
Rebecca Katz: Right. Essentially, any balanced fund that we have at Vanguard or anywhere else would, if it's a 60% stock fund, 40% bond fund, should be constantly rebalancing. So that's one way of kind of putting money in and not having to worry about doing that rebalancing yourself.
Kahlilah Dowe: Exactly.
Chris Philips: Absolutely.
All investing is subject to risk, including the possible loss of the money you invest.
For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the Fund name refers to the approximate year (the target date) when an investor in the Fund would retire and leave the work force. The Fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in the Target Retirement Fund is not guaranteed at any time, including on or after the target date.
Advice services are provided by Vanguard Advisers Inc., a registered investment advisor.
This webcast is for educational purposes only. We recommend that you consult a financial or tax advisor about your individual situation.
© 2014 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.
How to set and maintain the right asset mix
Whether your milepost is a date, a time of year, or a percentage, it's important to consider rebalancing your portfolio to your target asset allocation. Vanguard investment experts Chris Philips and Kahlilah Dowe discuss how to decide on the right allocation and outline the various scenarios that can help keep your asset mix where you want it.
Other highlights from this webcast:
- Four pillars for investing success
- Can I keep my assets in my 401(k) after I retire?
- Market volatility and your emotions
- All investing is subject to risk, including the possible loss of the money you invest.
- For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
- Advice services are provided by Vanguard Advisers Inc., a registered investment advisor.
- This webcast is for educational purposes only. We recommend that you consult a financial or tax advisor about your individual situation.