We've arrived at the final post of this 7 part series in designing a solid, low-cost, do-it-yourself portfolio. As we've discussed, the easiest (and undoubtedly one of the smartest) portfolios you can have is a fixed asset allocation of low-cost index funds. There are a few tasks that remains.
Tracking Your Returns
An important part of planning for the future and maintaining your asset allocation is to track your returns. This need not be done on a daily basis, but should at least be looked at once a year and tracked over the long term. I suggest you use XIRR to do so. As the years go by, this data becomes more and more valuable. If, for example, your plan for financial independence is to have $2 Million in 25 years, and you determined up-front that you need to save $42,000 a year and average 5% real returns (after taxes and expenses) to reach that goal, then you ought to calculate your returns as you go along to see how you're doing. If after 7 or 8 years you see that you're actually only getting 4% real returns, then you can adjust by saving more money or perhaps even taking a little more risk than you thought you had to in the portfolio. Perhaps your plan was to get 10% real returns, and you realize how unlikely that seems to be after a few years of investing. You can now adjust the plan to spend less in retirement, work longer, or save more now. Investing without calculating your overall returns is like going on a road trip and never looking at a map, a GPS, or the road signs. You may run out of gas before you get there.
A static asset allocation is going to be knocked out of balance by varying market returns. If you want to maintain the same level of risk in your portfolio, you'll need to rebalance back to the original asset allocation from time to time. For the beginning investor, with a small portfolio compared to his annual contributions, this is easily done by directing the new contributions to the asset classes that haven't done particularly well recently. As the portfolio grows, it may occasionally become necessary to actually sell something that has done well in order to buy something that hasn't.
Studies show you shouldn't rebalance more often than every year or two, so some people just do it on their birthday every year. Others rebalance when the portfolio becomes out of whack by a certain amount, by using the 5/25 rule (or similar.) You should try to avoid any tax consequences when rebalancing, as the benefit of rebalancing could easily be eliminated by the tax costs. This means doing your rebalancing predominantly within tax-protected accounts. You can also use distributions (dividends and capital gains) to new contributions to rebalance, further decreasing the need to sell appreciated securities within a taxable account.
Changing The Asset Allocation
You occasionally may come up with a good reason to change your asset allocation. This should occur rarely, and when I say that, I'm not talking every week or two. I'm talking once a decade or so. Remember, this is a strategic asset allocation we're talking about, not a tactical one. You don't change it in response to security valuations or recent market events. You need to be very careful about performance chasing, which is a very natural tendency that most investors fall into. I suggest you give yourself a waiting period, perhaps even 3-6 months after deciding to change the asset allocation before doing so. You may be surprised to see that after a 3 month wait you no longer think that change was such a good idea. Here are a few reasons why you might want to change your asset allocation:
Decrease in risk – In general, as you get older, closer to retirement, and closer to your financial goals, you probably want to dial down the risk a bit, with more safer assets like bonds, and less risky assets like stocks. You may want to decide now how you plan to do this. Decreasing stocks by 1% a year or 10% a decade or whatever. You may also find you simply don't need to take as much risk after a raise, particularly strong market performance, or an inheritance.
Change in life circumstances – Perhaps you get married and your spouse doesn't like you investing in microcaps, or you find you need a higher return than you originally anticipated. You may also gain access to different asset classes through a new 401K.
Add an asset class – Every now and then, a new asset class comes along. If, after evaluating it, you find you want to add it to your portfolio, it's okay to do so. I do recommend you be very careful about performance chasing, however. It's easy to do, even for the “right reasons.”
Buy into a new theory – You may come across some new investing research or theory that indicates a change in investing strategy. Examples from the past include the development of mutual funds, the development of index funds, the development of REITs, 3-Factor analysis into the benefits of small and value stock investing, or even momentum investing.
Stay The Course
Last, and perhaps most importantly, once you develop your portfolio, you need to stay the course. This is much easier said than done. Not only do you have to ward off the constant urge to tinker, but you need to avoid reacting to market ups and downs. It helps if you don't pay any attention to the financial news. Investment consistency is far more important than the particular asset allocation you choose (as long as it is something reasonable.) Changing horses in mid-stream is a recipe for getting wet.