The Biggest Portfolio Mistake?

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Right now, rich people are making a big mistake… one you could be making in your own portfolio.

Can you spot what it is?

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The chart above shows the breakdown of assets for high net worth individuals (HNWIs) – people who have investable assets of more than US$1 million, excluding primary residence and collectibles.

So what’s wrong with the chart?… or rather, where are rich people going wrong?

It’s not diversification, per se – as you can see, rich people have spread out their portfolios into different asset classes. They’ve got that angle down. It’s one of the things all rich people do (and it’s something you should be doing too).

But if you take a closer look at the chart, you’ll see that HNWIs have seen a dramatic reduction in real estate in their portfolios since 2013.

In 2013, the rich had 20 percent of their portfolio allocated to real estate. But as of this year, that allocation had declined 30 percent, to just 14 percent. Meanwhile, they have 31 percent of their portfolios allocated to equities, compared to just 26 percent in 2013.

This may be a strategic decision. Perhaps these investors decided to reduce real estate, and add to equities. They may have assiduously studied asset allocation models with their private bankers, perused the latest research, reviewed historical performance and applied regression analysis to derive a new allocation target.

Or, more likely than not, markets moved and these investors weren’t really paying attention. Unbeknownst to the investor, a very significant shift in asset allocations just… kind of happened. And it happened because they didn’t rebalance their portfolios.

And that’s a big mistake. If you’re not rebalancing your portfolio on a regular basis, you could be risking your wealth.


Why you need to rebalance

Picture a simplified portfolio where 50 percent is invested in stocks, and 50 percent is in bonds.

Now imagine that over the next 12 months, stock markets go gangbusters and are up 20 percent – while bond markets climb only 2 percent. Because of this big difference in performance, stocks now make up 54.1 percent of the portfolio… while bonds are at just 45.9 percent.

So now the portfolio is less diversified – and more at risk.

That’s because significant portion of the portfolio is now invested in one asset class than originally intended. If it was the plan to have 54.1 percent in stocks, fine. But if it wasn’t, then this portfolio is riskier than its owner thinks it is.

Left unchecked, a diversified portfolio can become unbalanced through performance. And it can happen without investors even realising.

That’s because, over time, higher-return (and higher risk) assets can increase their share and asset allocations can “drift” to the point where investors are more exposed to one particular stock or asset class than when the portfolio was set up.

How to rebalance

Rebalancing just means realigning the portion of each asset in a portfolio. In other words, selling “winning” assets that have increased their share of the portfolio since it was first created – and replacing them with other assets to balance out the risk.

The point is to make sure a portfolio isn’t too dependent on the success (or failure) of one particular stock, asset class or market.

Imagine a particular stock has performed well and increased its share of your portfolio. That’s good news – but now you’re more at risk if that stock falls because more of your portfolio is invested in it.

To reduce the level of risk, you just need to sell some of those equities and invest in other stocks. Now you’re back where you started.

Deciding when and how to rebalance is different for each individual investor. There’s no “one size fits all” solution. Different strategies work for different people.

Bear in mind, we still want to let our winning positions ride. Rebalancing doesn’t mean selling our winners, but it can mean trimming them down a little and taking some profit, in addition to closing out any poor performers or positions where the outlook has changed.

How to keep your portfolio’s balance

But there are three basic strategies to keep a portfolio in check:

1. Time: a portfolio is rebalanced after a specific period… once every six months or year, for example. Most passive investors use “calendar rebalancing” – checking their asset allocations on an annual basis to make sure they still meet their investment goals and appetite for risk.

2. Threshold: investors set a limit, similar to a stop-loss level, to prevent one asset drifting too far from its original allocation and rebalance once it reaches this limit (five percent on either side of the target, for example).

3. Time and threshold: as the name suggests, this is a combination of the first two strategies. The portfolio is checked at regular intervals, but isn’t rebalanced unless one of the assets has reached its predetermined threshold.

Of course, rebalancing involves the usual brokerage costs and trading fees, so it’s important to remember this when deciding how often to rebalance.

Trim the fat

Rebalancing protects investors from emotions that can lead to bad financial decisions (as we’ve written before). If one asset performed well last time, we tend to think it’s going to perform well next time too (that’s known as “status quo” bias).

But all good things must come to an end… and investors who are overweight in a particular stock or asset class are in for a bad fall when it does eventually happen.

Selling “winning” stocks and rebalancing or trading them for other, cheaper assets means investors are well positioned to profit from growing markets at lower prices.

In short, rebalancing helps you make the most of diversification. So while we generally think you should copy what the rich do, avoid the mistake they’re making right now and rebalance your own portfolio today.

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