Balancing Types of Investments

The common view toward seeking to balance the investments in one’s portfolio is that this should be done to achieve various investment strategies, ranging from what is seen as the most aggressive to the least, and look to match the balancing with the level of aggression sought.

Examples of this would be an all equity strategy for those who seek the highest amount of growth and the most aggression with their portfolio, or an all savings portfolio with those who choose the most safety and therefore the least aggression.

Depending on one’s investment objectives and risk tolerance, a combination of asset classes will be used in order to match up with these objectives, which generally means a certain percentage of one’s portfolio held in stocks and a certain percentage in bonds or preferred shares, with savings assets such as money market funds or certificates of deposits being used as well in cases where investors wish to add even more stability.

Generally, the focus will be on the growth and income asset classes, with stocks comprising the growth component and bonds primarily representing the income class, with the savings asset class playing a lesser role generally.

In terms of both growth potential and risk, the growth component would score the highest in both, with savings class investments being the lowest in both, and income class investments falling in the middle.

Deciding how one should balance one’s portfolio has to do with the amount of risk one is comfortable with, because there’s no reason to want to purposefully limit growth potential, but there are good reasons why one may not want to be exposed to too much risk.

How risk is assessed here is a combination of the investment time frame that an investor seeks, together with subjective considerations, one’s own personal risk tolerance. Taking this all into account, a certain proportion of these asset classes will be prescribed, and often the portfolio will be rebalanced to maintain this proportion in changing market conditions, such as stocks rising and some being sold off for bonds for instance to keep the desired balance.

How Much Sense Does This Strategy Make?

Many investors and investment professionals see portfolio balancing as a very sensible approach to portfolio management, and under the assumptions that are being used it certainly can be seen as sensible.

If the alternative here were to not pay attention to such things, for instance to put people with long term horizons and higher risk tolerance in too conservative approaches, or those with shorter time frames and less risk tolerance in too aggressive ones, then this isn’t going to be ideal at all, or even acceptable.

Within the set of assumptions that are made here, this all does make sense, as we do want to look to have the percentages of our portfolio that we hold in broad asset classes to match up with our overall investment strategies.

If the stock market declines for instance, it is better to not have those who are not prepared for such declines in the value of their portfolios to be less exposed to these risks, and also allow for those who are more prepared for these risks to be able to take more advantage of rising markets over time, which has tended to be the case in the longer term.

There are some assumptions that are made here that need to be valid for this approach to make sense though, and these are assumptions that we usually take for granted, usually not even questioning them.

Balancing Types of InvestmentsThe biggest assumption here is that the only way you can manage market risk is through the asset allocation that portfolio balancing seeks, in other words to keep a certain percentage in certain asset classes as means of diversifying.

If the stock market declines for instance, you are protected to a certain degree by having a percentage of your assets not in the stock market, which will generally lessen the blow, as your other investments probably won’t decline as much and may even increase in value to make up for some of your declined positions.

Another assumption that is made here is that risk management must be static, you are to decide this strategy with no regard to the market itself, and whatever strategy you decide on, half stocks and half bonds for instance, will be equally valid in all market conditions.

The third assumption is that there is only one way to invest, which to buy assets and hold them, limiting yourself to long positions where you gain if the price of your investments rise and lose if they decline.

Even considering moving around the mix of your investments in any sort of responsive way to the market isn’t considered, as any of this is outside the model essentially, the model is a completely static one and doesn’t really allow for any decision making apart from what is prescribed to you.

Static balancing is at least supposed to adapt to changing time frames, for instance as one’s time frame shortens over time, the balance of one’s portfolio should be adjusted to accommodate for this, generally seeking to become more conservative over time. We tend to pay less attention to this than we should generally and people are often left with too aggressive mixes at a time where their horizons are much shorter than they were back when the strategy was devised.

There are calculations that we often use based upon age, but even this tends to be on the more aggressive side, meaning not managing risk as well as we should. For instance, we may wonder why those in their retirement years who will be needing to cash in their assets should be in equities at all, due to not having a long enough time frame to manage the risk, especially if the market is declining.

What Should Balancing Really Look Like?

Simplicity does have its virtues, and the common approach to portfolio balancing is nothing if it is not simple. Whether we should sacrifice too much performance or especially sound risk management to simplicity is another matter.

Investors shoulder the blame here for the inefficiency of the common approach because they are the clients and they are getting basically what they are asking for here, where they just want to put their money in something and leave it, and be at least somewhat insulated from the real bad stuff.

If we truly want to balance our portfolios properly, then there isn’t a good way to do this without accounting for changing circumstances. If you are considering buying stocks or bonds, the market is of course going to matter, and if our strategy totally ignores these considerations, where we just close our eyes to anything that may be going on with what we’re looking to buy, that cannot be the best approach or perhaps not even a good one at all.

We should not be asking ourselves what sort of balance we should have as a once and for all, all encompassing, all things being equal strategy, because all things are not equal and they differ quite a bit.

If we seek to manage risk properly, that’s hard to do if we ignore what risks may be present right now. If we are deciding what assets to buy, how these assets are performing should at least matter.

Dynamic Portfolio Balancing

Ultimately, the best approach to portfolio balancing is to seek to balance one’s portfolio in a much more dynamic way than the purely static view that is generally used. If the outlook for stocks or bonds or whatever asset that we hold or are considering acquiring is grim, then it only makes sense to balance things away from it, to at least reduce our positions and move them into assets with a better outlook, even if that means going with assets that do not generally return as much, or even moving some assets to cash.

While this will increase our transaction costs a little, when we’re talking about looking to insulate ourselves against major moves in our position, these added transaction costs aren’t meaningful at all, especially in today’s very low cost trading environment.

There are traders who turn their portfolios over completely several times a day and have no problem making consistent profits this way net of transaction costs, even though the moves that they seek are very small, so doing so occasionally to adjust for bigger market moves and worrying about transaction costs really doesn’t make sense.

The criteria that one may use to make rebalancing decisions is also completely flexible, where an investor may revisit this only on an occasional basis, even every few years if one desires, or one may monitor this more tightly, where one may adjust things several times a year for instance, but the important thing is that this is stuff we should be paying attention to if we really want to manage risk.

In order to manage risk, one must do so actively, one must be responsive in other words, and with the ability to respond is not even incorporated in one’s balancing strategy at all, we may ask ourselves whether we’re managing risk very well at all if a major component of our strategy is to refuse to actively manage risk and just look to deflect a certain amount away, while deflecting our potential gains at the same time.

This is not something that you can just tell your mutual fund salesperson to do, and while you can hire advisors to manage this sort of balancing for you, this is expensive and is only available to those with large portfolios.

This can be achieved with mutual funds though, and without a lot of effort really, just by moving around the types of funds you hold in a more market responsive way than the buy, hold, and hope strategy that is generally used.

Mutual funds aren’t so trading friendly though, although another type of fund, exchange traded funds, are better suited to this dynamic approach and allows investors to balance their portfolios with more ease and less cost.

The challenge though in doing this is to be able to determine which assets you should be in at any given time, where the markets are trending for stocks, bonds, and so on in other words, and this does require a bit of skill, although not anywhere near as much as many people assume.

However, those who are prepared and willing to make the effort here can seek to balance their portfolios in a much more sensible way, where they seek to sail with the wind more, instead of just hoping the wind blows their way enough to preserve their future.

Andrew Liu


Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

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