Figuring out your future finances: rebalancing your portfolio, with Dozens

1. Asleep At The Wheel 😴

2:23 min read

Welcome back

If you’ve been following along with the other installments in this series, you’ll be in a pretty good place. You’ve assembled a pile of cash and decided what to do with it – likely choosing a strategy that splits it up between savings and investments. But you’re not done yet! You need to figure out exactly how to fork off your finances. And what’s more, there’s a need to tread carefully going forward – you don’t want to lose your balance…

How should I split up my cash?

First off, you’ve got to decide how much risk you can stomach. Different investments have different risks associated with them – cash in a savings account and most government bonds are very safe, corporate bonds are little riskier, and stocks are riskier still. Risk varies within those categories too: after all, not all companies are equal. Ford is much less likely to vanish overnight than yet another Uber rival 💨

Higher risk means higher potential returns, so depending on your personal situation you might want to weight things more heavily in one direction (more on this below). But you probably don’t want to put all your eggs in one stocky basket. Though different companies’ stocks move differently, the stock market as a whole tends to move in the same direction – the various stock movements are correlated. But some assets are uncorrelated (or better yet, negatively correlated). That means they don’t move the same way as other investments. For example, when stocks do poorly, bonds tend to do well (though that’s not a hard rule these days).

If your investments are spread across uncorrelated assets, then any losses in one should hopefully be offset by gains in others. Building a portfolio like this – a so-called diversified or balanced portfolio – minimizes your risk of losses compared to potential for returns. (Economists proved this mathematically back in the ‘50s – although some of the assumptions they used are still controversial).

So once I’ve built my portfolio, I’m done?

Not quite. Lots of investors choose a certain split (e.g. 60% stocks, 20% bonds, 20% cash), and make sure they stick to it over the long run. If your stocks gain and your bonds lose, stocks will become a bigger percentage holding of your portfolio – meaning the riskiness of your overall portfolio nudges upwards. To deal with this, investors rebalance: in this case, selling some of their stocks and buying more bonds to bring them back to that original, more comfortable, 60/20/20 allocation 😅

Selling your winners is counterintuitive, we know: that’s what this guide is for. We’ll walk you through the process of keeping your investments in check and how to know if you’re doing alright, as well as weighing up whether rebalancing is right for everyone. To start: how do you actually build a portfolio?

2. Cut The Cake 🍰

2:27 min read

Where should I invest?

As mentioned, you’re probably best off building yourself a diversified investment portfolio – a basket of investments from different, uncorrelated asset categories ⛹️‍♂️

Finance is a broad church, and there’s an investment out there for everyone. The main ones are stocks (shares of the ownership of a company – also known as equities), bonds (the debt of a government or company), different countries’ currencies, commodities (things like gold or oil), and real estate (your house, or the local shopping mall).

Different forces drive the prices of these investments. For example, stocks are closely linked to company profits, so they tend to gain when the economy is rosy and everyone’s making money. Bonds pay a fixed return, and so these do well in periods of low inflation (higher inflation erodes the value of their fixed payments). Conversely, gold is seen as a physical store of value; its value usually climbs when inflation spikes.

If you’re into something funkier, you can also get involved with a whole range of exotic assets: anything from rare wine to art. These have the advantage of being particularly uncorrelated with more mainstream investments, but you’re taking on a lot more risk as a result 😬

So how should I split my investments up?

We’re sorry to report that there’s no one answer. It’s always going to be a trade-off between potential gains and potential losses.

But to give you an idea, let’s compare two portfolios recommended by notable investors. Harry Browne, who sounds like a Cockney gangster but isn’t, devised the “permanent portfolio” – which splits your pot into four and allocates an equal amount to stocks, long-dated US government bonds, gold, and cash. This conservative strategy aims to provide reasonable gains no matter what the economy is doing.

The other portfolio was created by William Bernstein and consists of 25% big US stocks, 25% smaller US stocks, 25% non-US stocks, and 25% bonds. This is a more aggressive approach – its bigger reliance on shares gives it greater potential for both gains and losses.

A study comparing both between 2005 and 2018 found that Bernstein’s portfolio grew by an average of 7.25% a year – but at one point fell a shocking 42% (peak to trough). Browne’s allocation gained only 6.8% a year – but its worst dip was just 12.6%.

So which should I choose?

It entirely depends on your personal risk tolerance. If you’re young and willing to take a gamble, you could lean more towards stocks (in the long term, the stock market tends to do well). If you’re older and close to retirement, you’ll probably want more stability – so leaning more towards safer assets like government bonds might be worth the lower returns 🧓

No matter what, once you have picked an allocation, you shouldn’t just leave it: like a driverless car, a neglected portfolio might end up swerving off the road. Rebalancing, however, can help keep you on track.

3. The Straight And Narrow 🙆‍♂️

2:34 min read

Let’s say a legacy from a maiden aunt leaves you with an extra £1,000 available to invest. You decide to put 90% of it in stocks and 10% in bitcoin – the massive risks mean you don’t want to bet all the money on cryptocurrencies, but you think it’s worth a punt. It’s what Glenda would have wanted 🙏

Turns out you (and Glenda) were right: your £100 of bitcoin immediately shoots up in value to £1,100! Combined with the £900 worth of stocks, your portfolio is now worth £2,000: a delicious 100% return.

But your portfolio is now predominantly made up of bitcoin. Have a think: if Glenda had given you £2,000, would she really have approved of you putting 55% of it in bitcoin? Probably not – that’s pretty risky, even for a woman who did a bungee jump at 75. Your initial plan was to put only 10% of the cash in bitcoin: just because your gamble’s gone well doesn’t mean that it’s any less of a gamble, or that you should be taking on more risk than you’d wanted 😷

To bring your risk back down to your target level, you now need to rebalance. That means selling most of your bitcoin, leaving you with £200 worth – and using the proceeds from the sale to buy another £900 of stocks. You’re back to a 90/10 stock/crypto split, and your portfolio reflects the risk you’re actually comfortable with.

Doesn’t this mean selling the investments that are doing the best?

It does indeed. But that’s because you’re not gambling on individual assets – you’re trusting your asset allocation. It’s slightly counterintuitive, but by taking an action to buy and sell, you’re explicitly not taking a view on the success of any one investment. Rebalancing lets you take the emotion out of investing, and in doing so better manage your risk.

Some evidence suggests rebalancing is good for your returns, too. If, over the long run, your different investments’ gains average out – so bitcoin falls and stocks rise – then by cashing out your crypto once you’ve made a profit and putting that money in stocks, you should see better returns than if you’d just left your investments untouched. The theory here is that, like a pro surfer, you can keep on riding the good waves – without staying in any single tunnel long enough to wipe out 🏄‍♀️

How often should I rebalance?

It depends. Analysis from East West Investment Management shows that rebalancing on a quarterly basis might be best. Its dummy portfolio of Canadian stocks and bonds, split 60/40, performed best when it was rebalanced every three months – but the company found that any rebalancing is better than none at all.

If you’re using a robo-advisor, you might not have to worry about this – some platforms will automatically rebalance your investments for you at no extra cost. But if you manage your own portfolio, you’ll have to rebalance manually, buying and selling assets to keep everything at your target level.

And that’s one reason why some people advocate not rebalancing at all…

4. Tip The Scales ⚖️

1:57 min read

Why might I not want to rebalance?

Rebalancing means letting go of your winners. Pro investors like Warren Buffett advocate finding a few good investments that you think will keep delivering strong returns, and holding on to them… forever. Selling your strong performers in order to buy more of your weaker ones might not be the best move – especially if those weaker ones are increasing your risk (if a company’s finances are looking rocky, for example). Furthermore, changing economic conditions could make your initial split seem less wise over time: an environment in which interest rates are expected to rise makes existing bonds less attractive (and stocks more so).

There’s also some evidence to suggest rebalancing doesn’t always boost your returns. One investment strategist found that, when the assets in a portfolio provide about the same return over an extended period, rebalancing does better than a “buy-and-hold” strategy in two out of three cases. But on the rare occasions when buy-and-hold does better, it does way better – and so on average, the returns provided by both strategies end up pretty much equal. What’s more, if some of the portfolio’s investments increase more than others in value, a buy-and-hold approach can even provide a better average return than rebalancing 🧐

Added to this is the fact rebalancing is essentially “active” investment management. If you’re managing your own portfolio, you’ll likely be charged trading fees every time you tweak your holdings – and so overzealous rebalancing can quickly swallow up your precious profits.

What do the professionals do?

According to one finance professor, most professional investors don’t rebalance their portfolios. But that doesn’t mean you shouldn’t do so.

While it might not bring you better returns, rebalancing does help with risk. Sudden share crashes can wipe out your gains if you’re too heavily invested in the stock market. That doesn’t matter too much for professional investors who can always re-roll the dice, but if you’re close to retirement a big loss could be devastating. By making sure you always have a well-balanced portfolio, you can reduce the chance of any one event forcing you to stay in work forever 💀

Ultimately, only you can decide if rebalancing is worth the effort. But to do that, you need some means by which to measure your success.

5. All Things Considered 👨‍💻

2:11 min read

With all investing, the main thing to remember is that you’re taking on risk – that’s why you’re being rewarded with the potential for gains. So you should always compare the return on your investments (after fees) to what you could have got if you’d sunk all of your money into something with near-zero risk of losses. Professional investors call this the risk-free rate: they generally use 3-month US government bonds as a benchmark, as the American government’s never failed to honor its debts… yet 👀

That’s not the only comparison available, however. You might want to compare your portfolio’s performance with that of a broad measure of the stock market. The MSCI World Index is a good proxy of global stocks in rich countries, for example, while the FTSE 100 and S&P 500 track the share price performance of the biggest companies in the UK and US.

Try not to get too obsessed with comparing your portfolio to these indexes, though. Unless your portfolio is entirely in stocks, it’ll likely rise more slowly than the stock market. But you’re sacrificing those increased gains for lower risk: if the stock market falls, a diversified portfolio won’t be hit as badly.

Is there a way to take that into account?

There certainly is. Professional investors look at risk-adjusted returns. These aim to account for it being easier to win big if you take on lots of risk. One common measure is the Sharpe ratio, which is basically returns divided by volatility (how much prices swung up and down). The ratio is helpful for tracking the performance of a balanced portfolio, because it shows you if you could be doing better without taking on more risk.

You’ll need to do a bit of math to calculate this, but it could well be worth your while (plus it’s a chance to remember your school days 🤓). As a general rule of thumb, a ratio below 1.0 is considered poor – anything above 1.0 is decent, above 2.0 is good, and if you’re getting above 3.0 please give Finimize a call and teach us how…

What if making money isn’t my only measure of success?

Good for you, Enlightened One. Investors are increasingly taking into account how much positive impact their investments have on the world, whether they’re actively funding big renewable energy projects or just keeping their cash away from tobacco companies. It can be hard to quantify just how much impact your investments are making, but there are ways of evaluating how much of your portfolio is made up of “good” versus “bad” investments.

6. All Set? 👌

1:22 min read

In part one of this series, we explained the first step in figuring out your future finances – protecting the value of your money from inflation in a tax-efficient way, while making sure you can get access to your cash as and when you need it.

In part two, we explored what to do before investing, talked through how to work out how much you’re able to invest, and looked at the benefits and drawbacks of investing all at once or over time.

In part three, we laid out the differences between saving, investing, and trading, and how you can use all three when putting your money to work.

And in this guide, we’ve walked you through how to diversify your portfolio and choose an asset split that’s right for you and your risk monkey 🙈 We’ve discussed how to rebalance that portfolio over time, tweaking where necessary to ensure you’re still on track. And we’ve looked at how to measure your investments’ success to see if you should be doing anything differently.

Next up, in the penultimate guide in this series, we’ll help you take these tools and try them out – showing you exactly what you should be looking at when choosing an investment provider…

This guide was produced in partnership with Dozens.

Check out Dozens’ mini-website at finimize.com.

Dozens is not a bank. They are authorised by the Financial Conduct Authority as an e-money institution (FRN 900894) and also as an investment firm (FRN 814281). 
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