This question is in reference to my prior article, Everything You Ever Wanted To Know About Asset Allocation. The question is about how an investment portfolio can become unbalanced and why should you buy more underperforming assets. Here is Botong’s question:
Hi, I was just reading your article on asset allocation, and I don’t understand this paragraph.
This is where the magic happens with asset allocation. When your allocation shifted from it’s original percentage, you are selling some of the assets that have been doing well and use that proceed to buy more shares of assets that have been underperforming to restore the original percentages. This is basically a “buy low, sell high” technique.
Here’s a response from Mrs. Micah:
Great questions. 1) The portfolio becomes unbalanced when one asset outperforms all the others. Suppose that I have a very simplistic asset allocation of 50% stocks and 50% bonds. In the last year, let’s say that my bonds did decently but my stocks crashed. Now when you look at the overall money in my investing account, 70% of it is in bonds and 30% is in stocks (bonds didn’t increase by 20%, but I have less money overall such that that the original 50% plus its earnings now represents 70% of my total portfolio).
2) It’s important to distinguish between underperforming assets (individual stocks and bonds) and their asset classes. This was a bad year for stocks, mutual funds, and index funds. Does that mean that you shouldn’t ever buy them again? No. In other years, stocks and funds have brought in great returns, the market is cyclical that way. Buying more while the class is underperforming is actually the buy low part of the “buy low, sell high” goal that most investors have (or buy low, hold forever, sell higher).
In a year when stocks are a runaway success, it’s also important to rebalance periodically. That way, you don’t end up with 80% in stocks and 20% in bonds in a year like this one.
When it comes to underperforming individual assets (stocks, specific funds, etc), you shouldn’t throw good money after bad by buying more. Just because you invested in them before doesn’t mean that it’s a good idea to continue investing in those particular ones. You have to re-evaluate them the same way you did when you first bought them before you buy any more shares.
Here’s a response from Patrick at Cash Money Life:
Mrs. Micah hit the nail on the head, especially regarding why the portfolio became unbalanced in the first place. The various parts of the market rarely move at the same pace, so a balanced portfolio is bound to become an unbalanced portfolio over time.
Regarding your second question, “Why buy more underperforming stock? How do you know they will regain
performance?” the answer depends. Underperforming may mean “undervalued,” or it may mean “Bad! Stay away!”
The key to this is to look at the investment as if it were a new investment. Would you put money in it now if you didn’t already have money in it? Do you see value in the investment? This may be a difficult question to answer if you are investing in individual stocks, but if you are investing in an index fund, then you may just be buying the entire market at a discount. Even though the market is down roughly 40% over the last few months, now may be a good time to invest — so long as you are investing with a long term goal.
Here’s a response from Plonkee at Plonkee Money:
Yep, everything Mrs Micah said is right, and then Patrick.
Usually, your asset allocation doesn’t allocate assets to individual stocks/funds — that’s generally where the good money after bad comes in. But in general, if stocks are cheap now they’ll be expensive in the future and so on, and you want to try and maintain a certain asset allocation. At your stage your desired asset allocation for retirement investments shouldn’t change much over say 5 years.