This is a part of the Investing Series.

Something that people kept repeating and I didn’t understand when I started, was what “re-balancing a portfolio” meant.

I was imagining clowns and elephants on little blocks, but I was fairly sure it wasn’t as fun as that.

WHAT’S A PORTFOLIO?

A portfolio just means all your money.

They say portfolio to make you think of something like a folder to hold all of your investments in stocks, bonds, mutual funds, cash, etc.

WHAT DOES RE-BALANCING A PORTFOLIO MEAN?

The best motto to describe the act of “re-balancing your portfolio” is: “Not keeping all your eggs in one basket”

Photograph I took in Beijing, China

Re-balancing your portfolio means you’re just making sure you aren’t too heavily invested in one area versus another, based on what you’ve set out as your investing strategy.

It’s like adjusting the wheel of a car — you know how sometimes a car drifts to the right or the left sometimes because it it isn’t balanced or tuned up correctly?

Well re-balancing your portfolio is like taking the wheel and adjusting for it going too far left, or too far right, so that you’re going straight down the road instead.

You have to set a strategy or a roadmap of where you want your money to go, how much growth you want to achieve and what you want to do it with, and then STICK TO THE PLAN.

Stick to using something more like Google Maps, and don’t, under any circumstances, take Apple Maps and get lost in some ocean of bad investments somewhere.

HERE’S AN EXAMPLE OF RE-BALANCING A PORTFOLIO

Let’s say you have $1000 in your portfolio.

You may have decided you want to put 50% of your portfolio into Index Fund A, and another 50% into Index Fund B.

Your portfolio:

• $500 Index Fund A
• $500 Index Fund B

Well, over the year as you invest, let’s say Index Fund A does really well.

You had originally put $500 into Index Fund A, and it is now worth $700, you’re up $200!! YAY!

Index Fund B on the other hand, has gone down; you originally put in $500, but it’s now worth $400, you’re down $100. Boo hiss!!!

Your total portfolio is what it is today, also known as “market value” is the following:

Index Fund A’s Market Value $700 + Index Fund B’s Market Value $400 = $1100

You’re up $100 overall from your original investment.

But the problem is that you now have a lot more money in Index Fund A than you do in Index Fund B, which is not in line with your original investing strategy of a 50/50 split.

Index Fund A = $700 / $1100 = 63% of your money is in this fund

Index Fund B = $400 / $1100 = 37% of your money is in this fund

If you wanted to stick to your 50/50 split, you would need to move some money from Index Fund A to Index Fund B to even things out back to what it was in the beginning.

Think of it like re-distributing the wealth.

If your entire portfolio is now $1100, then 50% of that would now be $550.

THIS IS WHERE RE-BALANCING MAGIC HAPPENS

When you go to re-balance your portfolio, you would have to move $150 from Index Fund A to Index Fund B, so that they’re both now at $550, or 50% of your entire portfolio of $1000.

You can do this by selling, buying or exchanging your investments (depending on what you bought).

Et voila! You’re back to 50/50 split, as you had originally intended.

HOW OFTEN SHOULD I RE-BALANCE MY PORTFOLIO?

You can do it either every quarter (every 3 months), or every year at the end.

Any more than that, and it will (probably) not be worth your time and effort.

May even cost you a lot more money in fees if you are charged any to buy and sell.

I tend to re-balance about 4 times a year, because I take chunks of money and divvy it up into 25% chunks to take advantage of dollar-cost averaging.

WHAT IS DOLLAR-COST AVERAGING?

It’s just the idea that you are buying a fixed amount over the course of let’s say a year, and on AVERAGE you will pay less, than if you dump in all your money at once (like I do).

To use an example, let’s say you buy a pizza every month as a treat to yourself.

Some months, that pizza costs $10, sometimes it goes up to $11, and sometimes it goes down to $9 because of promotions.

At the end of the year, let’s pretend your average cost of 12 pizzas (one per month), works out to be about $10.50 per pizza.

You would have spent 12 pizzas x $10.50 per pizza = $126 in a year on pizzas

Now let’s say that I also decide to buy some pizza (unbelievable, as I don’t buy takeaway pizza*, but let’s go with this story), but I decide that I want to buy all 12 pizzas all at once in one month because I’m lazy and too impatient to wait for delivery, and I’m planning on eating 1 right away, and freezing 11 for the other months.

If I bought a pizza in a month where it cost $11.

I would have spent: $121 a year in pizzas and about $5 more than you!!

All because because I didn’t want to buy a pizza monthly and take advantage of (inevitable) dollar-cost averaging.

I just bought everything at once, whereas you wanted to buy one each month because you never know whether pizza workers are going to go on strike for more money which means the price of pizzas go up, or maybe it’s a bad month and the businesses need to give a little deal or promotion to get people to buy their pizzas.

All of this stuff happens in real life — stocks are up one month, down the next. The only way to take advantage of the lower-prices, is to buy in chunks, spread out over the year.

Otherwise, you’d be trying to time the bottom of the market and buy at the ‘cheapest possible’ floor, and that may not end well for you.

Update: I will be looking into this “value averaging” instead of dollar cost averaging that Jacq mentioned in the comments, and get back to you with a post on it.

*I don’t buy takeaway pizza because I’ve been horribly spoiled with delicious, homemade pizza.

There is no pizza I’ve ever purchased, that tastes as good as what BF makes at home.

PROOF!!

BUT WHY WOULDN’T I KEEP MY MONEY IN THE FASTEST GROWING FUND/STOCK?

You may be wondering why you would want to move money from an (obviously) great index fund to a crappier one (Index Fund B), or why wouldn’t you just put ALL your money into Index Fund A, and make out like a bandit?

This is because you can’t time the stock market, as evidenced in the years of 2008-2009, and if frankly, if people could time the market, they’d all be millionaires in no time.

In 2008-2009, anyone who had their money in bonds started seeing an increase in value because investors were fleeing the stock market and selling their equities or stocks in the stock market.

If you had most of your money invested in the stock market, you’d be down by a lot if you had sold at that point.

In contrast, if you had invested some of your money in bonds, you would have seen that money go up instead of down during that period, and perhaps the profits from bonds and the losses in stocks would have evened out for you.

You wouldn’t have freaked out as much, because you didn’t lose half of your savings over night.

(Plus it would have helped to not have sold anything and just waited for 5 years for your money to go back up.)

This is also called DIVERSIFICATION, where you don’t put all your money into one area — you put a little bit of it into each area, so that as one goes up, the other goes down, and in the end, you’re still making money.

Update: Jacq made a great point in the comments about how the bond bubble is pretty much done.

Don’t start putting all your money into bonds now!!

If you do, think about short-term bonds, not long-term ones, so that your money will take advantage of the better interest rates. Long-term bonds will just lock you in at low rates that you won’t be able to break out of.

I’ve seen the trend of people switching back to equities about sometime in November 2011.

That seems to be the time a lot of stocks started taking off, as people took money out and started re-investing it again, and I think it’s the swing back into equities.

IT ALL DEPENDS ON YOUR LEVEL OF RISK WHICH IS YOUR AGE

What it all boils down to is this: being heavily invested in one area over another, is risky (unless you just have money in bonds earning a measly 1% over time), and the amount of risk you can take depends on your current age.

If you’re younger (under 37 I’d wager), you can be more heavily weighted towards stocks because you have time on your side to recover from any portfolio losses.

As you get older and nearer to retirement, you should think about preserving your money, and start weighting it towards bonds so that the money WILL BE THERE when you go to retire.

Read: What kind of investor are you?

Otherwise, you might end up like some Baby Boomers who had to recently come out of retirement to make money to keep putting food on the table.

Photograph I took of an old Chinese woman in Shanghai trying to make a living.

STOCKS WILL (PRETTY MUCH) ALWAYS GROW MORE THAN BONDS…. I THINK

The general sentiment is that stocks will always return more on the whole than bonds, but they are STILL risky investments, even if you invest fairly conservatively.

Over the past 100 years of the stock market, it has always pretty much gone up over time, on a slow incline.

Sure, there were jagged bumps and dips, but the direction is UP, because the stock market continues to get bigger because more money is invested each year, simply because the world population is growing, and there are more people alive today, than 100 years ago.

If you stick all your money in bonds, you will lose out on gains over time (and inflation eats it).

If you stick all your money in stocks, you are risking your nest egg.

The best strategy is always a balanced one, if you don’t want stress and to worry about your money all the time but you still want to preserve your wealth with some moderate growth.

SO HOW DO I KNOW WHAT TO PUT MY MONEY IN WHAT?

Some people say to take your age.

If you’re 30, you should have 30% of your money in bonds, and 70% in stocks.

Of course, this is assuming your life span is 100, so seeing as people generally live until 77 – 82 years of age, not 100 years old, you can weight it on something more mathematical by age.

Such as: 82 / 4 = 20.5, so you should have 25% of your money at age 20 – 21 (which is at about 25% of your life span), invested in bonds, and 75% in stocks.

Or maybe you just FEEL like you should have 20% in bonds, and 80% in stocks because you’re young, and you have time on your side.

Whatever you decide to do and however you want to calculate it, you have to do it based on how far away you are from needing all that money you’re saving.

SO WHAT’S THE POINT?

The whole point is when you invest, you need to keep an even, steady growth and to not risk losing all your money over night.

This means ignoring what your impulsive human heart tells you to to (put all your money into the fastest growing fund and stock and watch it rise!!), and following a rational, measured, lower-growth-but-wealth-preserving strategy that may be boring, but won’t make you sob in the corner from a drop in the markets.

If you’re invested in all areas of the market, you won’t have to worry (too much) when things go south for one area or another because things are going north for another part of your portfolio.

SUMMARY

• A portfolio is all of your money with a business-y name for it
• Re-balancing a portfolio is just making sure you adjust your investments
• You should think about re-balancing 1-4 times a year (depending on fees/costs)
• Dollar-cost averaging is buying small amounts over a period to get an average cost
• Timing the market is stupid; no one can claim to know anything definitively
• You shouldn’t put all your money into one stock or one fund, or style; diversify!
• Where you put your money depends on your age, and what you want to do with it
• Spend time and think about what kind of investor you are!