In last week’s blog, we discussed diversification using an investment example from the islands of Hawaii. This week, we are going to expand on the example to talk about allocation, reallocation, and rebalancing.
In basic terms, asset allocation is the process of dividing your assets among different investments in order to balance the risk and reward within the portfolio.
To better understand the risk/reward balance, let’s go back to the Hawaii example. We discussed investing in two different companies: one that sold sunscreen and one that sold raingear. What we didn’t discuss was the percentage of our investment that we should allocate to each.
While it may be easy to split the investment 50-50 between the two, it may not be the best idea. We invested in raingear in order to make the impact of the rainy season on sunscreen sales not hurt so badly. However, the rainy season does not last for 6 months. It only lasts for about 4 months (about 33% of the year). Also, even though the rain can seem endless, it doesn’t rain every day.
Here is where the risk/reward balance comes in. If we invest 30% of our assets in the company selling raingear, we are taking the risk that it will rain 30% of the time in Hawaii, rewarding us with earnings when sunscreen is not selling.
Let’s continue to pair up the example with last week’s illustration and throw in some real numbers. Say that we have decided that the 30% allocation to the raingear company and 70% allocation to the sunscreen company is the best way to go and that we invested $10,000 total ($3,000 and $7,000, respectively). A year passes, and the rainy season wasn’t spectacularly dreary, and your investment in the raingear company actually went down by 5% (a $150 loss). However, the tourist season was better than ever, and people were flocking to the sandy island shores – your investment in the sunscreen company increased by 10% (a $700 gain).
Now, your portfolio balance is $10,550, and your portfolio is allocated 73% toward sunscreen and 27% toward raingear. You have decided that you would like to adjust your allocation so that it again reflects the 70-30 split that you originally invested. You take some money from your sunscreen investment and put it towards the raingear to achieve your original allocation. This is known as rebalancing the portfolio.
As we said last week, you decide to change up your portfolio and invest in some companies on the mainland. Let’s assume that you invest your assets so that your portfolio now only holds 35% in sunscreen, 15% in raingear, and the remaining 50% in the mainland companies. You have now effectively reallocated your portfolio.
Wahoo! We just got through three more investment terms, and in one post! Join us next time as we delve into stocks and bonds. As always, if there is anything you want to know more about, give me a shout at Allison@iomechallenge.org.