“Even if you are new to investing, you may already know some of the most fundamental principles of sound investing. How did you learn them? Through ordinary, real-life experiences that have nothing to do with the stock market.” ~SEC.gov~, “Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing”

Diversify your assets: an example of stock vs. bond mutual funds

“Don’t put all your eggs in one basket” is the fundamental principle of investing diversification. By investing in various types of financial assets, such as stock and bond mutual funds, you protect yourself from drastic swings in your investment value. You’re also less likely to sell after a market drop.

Here’s how it works:

Jasper had 100% of his $100,000 investments in stock mutual funds. In 2008, when the market dropped 36.55%, the value of his investments fell to $63,450. Jasper, afraid of losing any more money, panicked and sold all of his stock funds. He was completely out of the stock market in 2009 when the S&P 500 returned 25.94% and in 2010 when the annual market return was 14.82%.

Imagine that Jasper’s investments were better diversified and he had 70% of his assets in stock funds and 30% in bond funds. During that same year, the 10-year treasury bond returned 20.10%. In 2008, with a 70%-30% mix of stocks and bonds, instead of falling 36.55%, Jasper’s investment portfolio would have dropped a more tolerable 19.56% to $80,445. The calculations: {100,000 x ([30% x 20.10%] + [70% x -36.55%])}.

With the smaller decline in his investments, Jasper would be better able to hang on during the market decline and could have profited from the subsequent 7-year bull market.

Historically, stock returns outperform those of bonds. But stock returns are more volatile. By combining stock and bond funds you profit from solid investment returns and fewer ups and downs in price. This will help you stick with your asset allocation plan.

The age formula for determining your fund percentages

If you’re younger and trust yourself not to bail at the slightest price volatility, you’ll choose a greater percent of stock funds and a lesser amount of bond funds. Older investors, with less time to make up any investment losses, generally hold proportionately fewer stock investments and more dollars in bond funds.

A simple formula to determine your asset allocation is to take your age, and subtract it from 120. That gives you a suggested percent of investments for the stock part of your investment portfolio. The remainder goes into bond funds.

Crystal is 36 years old. According to the above formula, Crystal should have 84% (120-36) invested in stock funds and the remaining 16% in bond funds. This isn’t a hard and fast rule. If you tend to be more conservative and might sell at the slightest drop in your investment values, you’re better off placing more of your retirement and investment savings in bond investments and a lesser percentage in stock funds. Additionally, there are many online risk quizzes to help you figure out an asset allocation.

Crystal might have her investments allocated 84% in stock funds, and 16% in a bond fund. This asset allocation could be created with 3 funds; 60% in a total stock market index fund, 24% in an international stock index fund and the remaining 16% in a diversified bond fund.

84% Stock Funds

• 60% Vanguard Total Stock Market Index Fund (VTSAX)

• 24% Vanguard Total International Stock Index Fund (VTIAX)

16% Bond Fund

• 16% Vanguard Total Bond Market Fund (VBTLX)

Once you select your asset allocation, how long do you stick with it?

How to change your asset allocation

There are several ways to change your asset allocation.

At the beginning of the year, 36-year-old Crystal’s $20,000 investment account reflects her preferred asset allocation and looks like this:

Beginning of the Year Asset Allocation – $20,000 Portfolio

By the end of the year, after contributing an additional $5,000, with appreciation and the additional cash, her investment account is worth $26,750. During the year, stocks outperformed bonds and her asset allocation percentages diverted from their initial target. By the end of the year, her asset allocation looks like this:

End of the Year Asset Allocation – $26,750 Portfolio

The goal is to return her investment portfolio back to its original allocation. Several strategies can get you back to your asset allocation target percentages. Additionally, there are online investment education services and tools to help automatically rebalance your investments as well.

1. Rebalancing Investment Strategy – Change Future Contributions

Whichever rebalancing approach you choose, understand that stock and bond prices fluctuate daily. Thus even after rebalancing, your investment totals will stray from their exact allocations. This isn’t a time to worry about a ‘perfect asset allocation’.

If you’re investing each month in your workplace 401(k) plan, you can direct future contributions to the under-allocated fund and away to the fund that’s grown most quickly. For example, the Vanguard Total Stock Market Index fund grew to 65% of Crystal’s portfolio, 5% greater than the 60% preferred allocation. Crystal can reduce the future contributions to 56% or so to grow that portion of her investments more slowly.

To lower the 19% Vanguard Total Bond Market Fund from its current percent allocation back to the preferred 16%, she can decrease her future contributions into this fund slightly to 13% or 14%.

Increasing the percent invested in the international fund going forward to 30% or 31% will increase the amount in the international stock index fund which underperformed the most during the year. This is a ‘good enough’ approach, not an exact and immediate rebalancing.

At mid-year, or at the end of the year, Crystal can check the asset allocation to see if it’s grown closer to her preferred percentages and readjust accordingly.

1. Rebalancing Investment Strategy – Sell and Buy

Another rebalancing approach is to sell the overvalued assets and use the proceeds to buy more of the undervalued funds. You can do this once per year, and keep the new contribution percentages the same.

The new asset allocation would look like this:

Rebalanced Asset Allocation – $26,750 Portfolio

Crystal could buy and sell shares of her funds until they reached the desired asset percentage combination.

Final thoughts about changing your 401(k) setup

In “Best Practices for Portfolio Rebalancing”, Vanguard states that “the asset allocation decision—which takes into account each investor’s risk tolerance, time horizon, and financial goals—is the most important decision in the portfolio-construction process. This is because asset allocation is the major determinant of risk and return for a given portfolio.” Poor asset allocation is one of the most common and expensive 401(k) mistakes.

There are volumes written about the benefits of portfolio asset allocation and rebalancing. It’s widely accepted that a sensible asset allocation, in line with your risk tolerance leads to better and less volatile investment returns. When and how you change your 401(k) mix on a short-term basis is less important than remembering to check in on your investments each year and getting them back in line with your initial preferences.