Investing our money across different investment types is called asset allocation. The ratio of money invested in different investment types is termed allocation ratio.

In this article, we'll look at two related concepts: how to invest our money efficiently across multiple investments, and how to maintain the allocation ratio even as different investments grow at different rates.

Asset Allocation

As we just mentioned, asset allocation is essentially spreading our money across different investment types. There are several reasons why we might want to do this:

• Growth characteristics: Different types of investments grow at different speeds. Their gains could also go up and down for various reasons: market cycles (e.g., retail stores do well around holidays, real estate prices could be cyclical over a couple of decades or so), company performance, global events, etc. As prudent investors, we do not want to keep all our eggs in one basket; we spread the investments across different investment types such that when one goes down a bit, any resulting loss is somewhat compensated by the other investments so that, over time, our gains continue to steadily grow.
• Our risk tolerance: Our allocation is also influenced by our tolerance or aversion to risk. For example, when we are younger we might invest more in higher-risk higher-reward investment types such as stocks. As we mature in years, we might slowly reduce the percentage invested in these and move them to a lower-return but lower-risk investments such as government bonds. Or, if a certain investment type seems to be more volatile than others currently, we might temporarily reduce our allocation in that investment type.

Dynamic Allocation

An asset allocation ratio doesn't have to be cast in stone. The ratio can be dynamic, allowing us to fine-tune the allocation ratio over time if our financial goals or risk tolerances change. Some investment companies themselves support dynamic allocation ratios — we'll briefly discuss them below.

Asset Rebalancing

As time goes by, we want to ensure that our allocation ratio stays where we want it to be. If one investment grows faster than others and skews the allocation ratio, we want to transfer some of the gains made there to the ones lagging behind in order to 'rebalance' the allocation ratio — hence the name 'rebalancing'.

There are several reasons why asset rebalancing is a good idea. There are also some instances where rebalancing might not make sense.

Rebalancing Benefits

• It ensures that our investments stay within our risk tolerance threshold.
• Creating a strategy and sticking to it for a while instills some discipline in us.
• It forces us to monitor and review our investment performance periodically.
• It acts as a reminder for us to not get too greedy about temporary growths. A growth in one year doesn't necessarily mean growth in the next year too. Rebalancing allows us to transfer the excess to a safer investment type, thus preserving the gain.
• If our investments are in qualified retirement mutual funds, it might be possible to transfer money between these funds at no charge. And such transfers may also be tax-free. Check with your mutual fund company for details.

Disadvantages of Rebalancing

There are, of course, a few reasons to not rebalance:

• Suppose we've invested in a high-growth investment (say, stocks) and the market continues to grow, hinting that the gains may continue for a while. In this case, transferring some money out of the growing investment could cause us to miss further gain, should the growth trend continue.
• Taking money out of an investment could result in tax payment.

Note that if the allocation ratio has become skewed because an investment has done poorly, we need to address the poor performance instead of blindly rebalancing the investments, as this will unnecessarily penalize the other investments that are doing well.

Rebalancing shouldn't be confused with dynamic allocation ratios. They serve different purposes. Dynamic allocation ratios allow us to modify the ratio of different investments. Once the allocation ratio is set, rebalancing helps us maintain the ratio.

Types of Rebalancing

Rebalancing can be either schedule-driven or threshold-driven. In the schedule-driven way, we review the performance of our investments periodically (typically once a year) and rebalance if needed. The threshold-driven way requires us to frequently monitor the performance (often automated; we are notified when any deviation from the allocation ratio is detected) and perform any needed rebalancing right away. Though the threshold-driven way tracks our allocation ratio more closely and is thus more accurate, most people prefer the schedule-driven for a few reasons: a) it is easier — for example, we can set an annual reminder to review our investments; b) reviewing periodically (say, once a year) is sufficient for most of our needs; c) lesser instances of rebalancing typically results in lesser tax.

Steps

There are a few ways to implement asset allocation and rebalancing. One way is to take advantage of investment products — such as 'balanced' and 'target' mutual funds — that automatically do these for us:

• Balanced mutual funds: These funds only require us to specify the allocation ratio. The fund managers then proceed to do the investments automatically for us and also typically rebalance the investments periodically.
• Target mutual funds: These are similar to balanced funds in that they do the asset allocation and rebalancing. But, instead of specifying the allocation ratio, we specify the target year when we expect to use the money from the fund (e.g., child's college education, our own retirement, etc.). The fund managers then use a dynamic allocation strategy so that the allocation ratio gradually varies over time to maximize the return and minimize risk.

Another way is for us to manage asset allocation and rebalancing manually:

• Decide on the allocation ratio (with the help of a competent financial advisor) and then (use the services of financial advisors to) invest our money accordingly.
• We can continue to track the performance of the investments and direct the financial advisors to perform any required rebalancing.
• Additionally, as the market or our risk tolerance changes, adjust our allocation ratio to reflect these changes.

Of course, we can use both the strategies — invest some of our money in a 'balanced' or 'target' mutual funds that are automatically rebalanced, but use a 'custom' allocation strategy for the rest of our investments.

Several financial advisors perform these steps for us, even when not using 'balanced' or 'target' mutual funds. Find a competent financial advisor and discuss your goals, lifestyle and financial needs to identify the strategy that best suits your needs.

Summary

Asset allocation and rebalancing are well-known strategies that help us stay true to our investment goals and risk tolerances. These allow us to maximize our returns without overly increasing our risk.