Monitoring your risk level and rebalancing
Points to know
- The risk level of your portfolio can change over time.
- If it gets too far off your original plan, you'll need to bring it back into balance.
- Your target asset mix may also need to change over time.
Don't lose your balance
It might seem surprising that your portfolio's risk level could change even if you didn't change any of your investments. But when one asset class is doing better than the others, your portfolio could become "overweighted" in that asset class.
For example, imagine you selected an asset allocation of 50% stocks and 50% bonds. If 4 years go by during which stocks return an average of 8% a year and bonds 2%, you'll find that your new asset mix is more like 56% stocks and 44% bonds.
Check your portfolio at least once a year, and if your mix is off by at least 5 percentage points, consider rebalancing. There are a couple ways you can do this.
The sum total of your investments managed toward a specific goal.
Usually refers to investment risk, which is a measure of how likely it is that you could lose money in an investment. However, there are other types of risk when it comes to investing.
A major type of asset—stocks, bonds, and short-term or "cash" investments.
The way your account is divided among different asset classes, including stock, bond, and short-term or "cash" investments. Also known as "asset mix."
Usually refers to common stock, which is an investment that represents part ownership in a corporation. Each share of stock is a proportional stake in the corporation's assets and profits.
A loan made to a corporation or government in exchange for regular interest payments. The bond issuer agrees to pay back the loan by a specific date. Bonds can be traded on the secondary market.
To move money in your account so that your overall portfolio aligns with the asset mix you selected, usually after market movements have caused it to change.
Buy more of one kind of asset
In the example above, you have too much in stocks and not enough in bonds. So you could direct additional money to your bond investments to bring your portfolio back in balance. (The money could come from new investments or from distributions.)
Move money from one type of asset to another
You could also move some money from your stock portfolio into your bond portfolio. This will immediately realign you with your target.
Note that if you invest in a taxable account, selling investments that have gained value will most likely mean you'll owe taxes. To avoid this, you could rebalance only within your tax-advantaged accounts. You can ask a tax advisor if you have questions about your own situation.
The trading of a universe of investments, based on factors like supply and demand. For example, the "stock market" refers to the trading of stocks.
The danger of not rebalancing
It can be hard to convince yourself to rebalance. Selling "winning" shares probably goes against your instincts. But it reflects one of the simplest distillations of investing wisdom: "Buy low, sell high."
If you don't rebalance, you'll wind up with an asset mix that doesn't match your risk tolerance.
Having a larger-than-planned allocation to stocks may seem harmless when stock prices are up. But no market rally lasts forever, and when the tide turns, you'll be overexposed to the drop. As the chart below shows, someone who never rebalanced would likely see his or her portfolio's risk level (as measured by allocation to stocks) increase consistently over time.
Time to rebalance? We can help
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Life changes—so should your risk level
There are a lot of reasons you might need to rethink the amount of risk you're taking.
If something significant has changed with your overall goal or with your life circumstances, you should check your asset mix and see if it still works for you.
For example, your timeline is always growing shorter. An asset mix that worked for a goal that was originally 20 years away might not be appropriate when your goal is now only 5 years away.
The amount you're shooting for may change too, if you find out you need less or more than expected.
Or you could discover that your risk tolerance isn't as high as you thought it was. Seeing your balance drop significantly might not be too scary in theory—but the reality often is harder to take. If you find that you can't stomach the ups and downs, it's time to change your plan.
SEE THE RESEARCH
Trying to increase returns by jumping in and out of specific asset classes, rather than following a specific plan, has proven challenging even for professionals.
All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments. Investments in bonds are subject to interest rate, credit, and inflation risk.
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