Why Review & Adjust Asset Allocation? Staying on Track Over Time

Imagine you’re planning a long road trip. You wouldn’t just set your destination and start driving without checking your route, the weather, or the traffic conditions along the way, right? Investing and managing your finances is quite similar, especially when it comes to something called asset allocation.

Asset allocation is simply how you decide to spread your investments across different categories, known as asset classes. Think of asset classes as broad groups of investments with similar characteristics. The most common ones are:

• Stocks (or Equities): Represent ownership in companies. Historically, stocks have offered higher potential returns but also come with higher risk.
• Bonds (or Fixed Income): Represent loans you make to governments or corporations. Bonds are generally considered less risky than stocks, offering more stable returns but typically lower growth potential.
• Cash and Cash Equivalents: Include savings accounts, money market funds, and short-term certificates of deposit (CDs). These are the safest and most liquid assets but offer the lowest returns, often just keeping pace with inflation or slightly above.
• Other Asset Classes: These can include real estate, commodities (like gold or oil), and alternative investments, which are often more complex and may not be suitable for all introductory investors.

Deciding how to allocate your investments across these asset classes is a cornerstone of building a sound investment strategy. It’s not a one-time decision, however. Just like you need to check your road trip progress and adjust your route if needed, you need to regularly review and potentially adjust your asset allocation over time. But why is this so important? Here are several key reasons:

Firstly, your financial goals and time horizon change. When you are younger, with a longer time horizon until retirement, you might be comfortable taking on more risk in your portfolio. This often means allocating a larger portion to stocks, which have historically provided higher long-term returns. However, as you get closer to retirement, or if your life circumstances change – perhaps you’re buying a house, starting a family, or facing unexpected expenses – your risk tolerance might decrease. You may need to shift towards a more conservative allocation, with a greater emphasis on bonds and cash to protect your accumulated wealth. Regular review ensures your asset allocation remains aligned with your current goals and the time you have to achieve them.

Secondly, market conditions are constantly fluctuating. The performance of different asset classes varies significantly depending on economic cycles, interest rates, inflation, and global events. For example, during periods of strong economic growth, stocks might perform exceptionally well. Conversely, during economic downturns or periods of uncertainty, bonds might become more attractive as investors seek safety. If you set your asset allocation and never looked at it again, you could end up with a portfolio that is no longer optimized for the current market environment. Regular review allows you to understand how market changes are impacting your portfolio and make informed adjustments to maintain your desired risk level and potentially capitalize on emerging opportunities.

Thirdly, asset class performance naturally drifts over time. Let’s say you initially decided on a 60% stock and 40% bond allocation. If stocks perform exceptionally well over a few years, your portfolio might become heavily weighted towards stocks, perhaps shifting to 70% stocks and only 30% bonds. While this growth is positive, it also means your portfolio has become riskier than you initially intended. This is because stocks are inherently more volatile than bonds. Reviewing your asset allocation and rebalancing—selling some of the overperforming asset class (stocks in this example) and buying more of the underperforming one (bonds) to bring your portfolio back to your target allocation—is crucial. Rebalancing helps you maintain your desired risk level and can also be a disciplined way to “buy low and sell high,” as you are selling assets that have become relatively expensive and buying those that are relatively cheaper.

Finally, your personal risk tolerance can evolve. Even if your financial goals and time horizon remain the same, your comfort level with market volatility and potential losses can change over time. Life experiences, increased financial literacy, or simply a shift in personal perspective can influence how much risk you are willing to take. Regularly reflecting on your risk tolerance and how comfortable you are with your current asset allocation is essential. If you find yourself feeling increasingly anxious about market fluctuations, it might be a sign that your asset allocation needs to be adjusted to better align with your current comfort level.

In conclusion, reviewing and adjusting your asset allocation is not a sign of panic or instability; it’s a sign of proactive and responsible financial management. It’s about ensuring your investment strategy remains aligned with your evolving goals, changing circumstances, market dynamics, and personal risk tolerance. By making this a regular part of your financial routine, you are much more likely to stay on track towards achieving your long-term financial objectives and navigate the ever-changing landscape of investing with greater confidence.