Investing in a retirement account isn't a onetime decision. It's more like a process. At a single point in time, a decision is made to invest money in a certain way, but as time moves forward, balancing that retirement account becomes important too.
What exactly do we mean by keeping an account in balance? Balance is all about understanding, accepting, and controlling risk. Most individual investors attempt to control risk by diversifying the asset mix in their investment portfolio.
A diverse retirement account might consist of a mix of stocks, bonds, and perhaps a fixed-income fund such as a money market account. Even within these three broad categories, there are subcategories of investments. For example, the portfolio might include foreign and domestic stocks, or long and short-term bonds.
By owning a mix of these types of assets in a retirement account, it's possible to diversify the risk associated with any one particular investment type. Under certain economic conditions, bonds will perform better when stocks decline. Money market accounts might provide a more reliable source of income during a bear market.
The point here is that at the exact moment an individual allocated their retirement funds to a certain class of assets, whether implicitly or explicitly, they allocated funds in a way to control risk. Over time, it's important to make sure a retirement portfolio continues to reflect the balance, or risk, that an individual is willing to accept with these investments.
Overall, there are two reasons why a retirement account can get out of balance. It's important to understand both concepts so we, as investors, know what we need to do to bring our accounts back into balance. The two most important factors include:
Each of these concepts are explained in more detail in the sections below, including examples of how retirement accounts can get out of balance.
The asset allocation of most actively-funded retirement accounts is affected by two forces. The first has to do with the performance of each asset type, and the second has to do with new funds added to the account over time. Each of these factors will influence the total funds in each asset class. However, the account holder has very little influence over the performance of each asset class relative to one another.
Unless all of the investments are in a single asset class, each asset's return on investment will grow in a way that influences the overall asset mix or allocation. This concept is best explained by using an example.
We're going to limit the number of variables to demonstrate how return on investment affects an account balance. Our retirement portfolio will initially consist of a $10,000 investment of 50% stocks and 50% bonds. The stocks in this portfolio produced an average annual return of 11% over five years, while the bonds provided a return of 5% over the same timeline.
It's safe to assume that our investor was knowledgeable about risk, and made a conscious decision to control risk using this particular asset allocation. So the initial investment mix looked this way at the start:
|Year 0||Account Balance||% of Portfolio|
Over time, the stock portfolio outperformed our bonds; so the stock's account balance grew at a faster pace. At the end of Year 5, the new account balances and portfolio mix looked this way:
|Year 5||Account Balance||% of Portfolio|
This example clearly demonstrates why it's necessary to rebalance an investment portfolio. In only five years, 57% of investments are now in stocks and only 43% in bonds. The overall risk of the portfolio is now much different than it was the day the portfolio was created.
The second dynamic driving the need to revisit a retirement account's asset allocation has to do with individual risk profiles. Admittedly, the amount of risk an individual is willing to accept will vary from investor to investor. That being said, there is one overall statement that holds true for everyone:
The level of acceptable risk for each investment portfolio will vary over time.
The most common example cited in this area includes the risk associated with retirement accounts as the retiree starts to depend on those funds for income.
When the accountholder was younger, they were willing to accept more risk with the hope of higher returns. If a bear market appeared, and their investment in stocks declined, this was an acceptable outcome. After all, they might have 20 or 30 more years before they intended to withdraw money from their 401(k) or 403(b) plan.
On the other hand, an investor that plans to use their retirement fund as a reliable source of income might not be comfortable with a large decline in their portfolio's value; even for a short period of time. This investor's individual risk profile would be very different than someone that doesn't need to withdraw money from the account for 20 or 30 years.
Now that we've explained why the mix of assets in a retirement account are so important, it's time to talk about ways to get those accounts back in balance. To achieve this objective, the investor has only two choices:
The first option, making direct adjustments and reallocating funds, is the more disruptive of the two choices. This particular option may be the best choice in cases where the investor has ignored an account for quite some time, and it is severely out of balance, or an event has caused their risk profile to change dramatically.
The second option allows the investor to slowly bring their retirement account back to an acceptable balance by allocating new funds in a way such that under-funded asset classes are provided with more money over time. In fact, the ideal way for an investor to keep their account in balance is by making new investments that are aligned with their portfolio's overall objective. This concept is one of constant rebalancing.
Individuals wondering what might be an acceptable level of risk for any type of investment portfolio will find investment calculators helpful. In particular, there are asset allocation calculators that ask six simple questions about risk and reward, and then suggest an asset allocation that is aligned with the answers provided by the end user. Our online calculator comes complete with instructions, and even provides the end user with a risk tolerance score.
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