Investing really is a balancing act. You’re walking on a tightrope with financial freedom on the horizon. But without a net, one misstep can mean falling and losing it all.
But invest wrong and you could lose everything.
A balanced portfolio is the net under your tightrope. It makes investing safer. We’ll show you how to create a balanced portfolio that meets your needs and keeps your money in your hands.
What is “Balancing Your Portfolio”?
To balance your portfolio, you’ll need to know what it means “balance your portfolio.”
The first rule of having a balanced portfolio is that you don’t put your money in just one place. Think of investing as a scale. It’ll never be balanced if you put everything on one side.
When you put your money in different places, you’re diversifying your portfolio. When you diversify your portfolio, you lower your chances of losing everything.
But simply diversifying your investments isn’t enough to protect your cash. You also need to learn to balance and rebalance your portfolio.
The goal of balancing your portfolio is to make investments that align with your risk tolerance.
Here’s a simple example. Let’s say you have two investment options
Investment A offers returns of up to 25 percent in a year. It may lose up to 30 percent of its value in a year.
Investment B offers returns of up to 10 percent in a year. It may suffer a maximum loss of 15 percent in a year.
A “play it safe” investor probably wouldn’t feel comfortable losing more than 20% of their portfolio value in a single year. If there were only two options, this person would decide to invest their entire portfolio in Investment B. This would keep them within their comfort zone.
That being said, A and B aren’t their only options. And that’s a great thing. Investment B is more conservative than this investor’s maximum comfort level. This means this person would be getting lower returns for the price of safety.
In order to increase their returns while still managing their risk, this person could balance their investments.
They can use both Investment A and Investment B together to match their comfort level. To achieve the maximum return on a safe investment, the “play it safe” investor puts two-thirds of their portfolio in Investment B and one-third of their portfolio in Investment A.
This mix increases the maximum potential returns in a year. Now, the investor can earn a maximum of 15 percent rather than the 10 percent Investment B offers.
Unfortunately, investments aren’t an open face card game. They don’t work like the textbook example above. You won’t know the maximum return or the maximum loss any investment may yield until you hit it.
That being said, you should have a good idea of the risks that come with your investments—namely the asset classes they fall into. You can also research how one asset class acts in relation to another asset class.
These relationships will help you pick suitable investments for a portfolio that matches your ideal risk tolerance.
What Are the Major Asset Classes?
You know your portfolio should be balanced and you have an idea of what that looks like. Now it’s time to learn which asset classes you should use to create your perfectly balanced portfolio. Traditionally, there are 4 major asset classes:
- Real estate
Each traditional asset class comes with benefits and drawbacks.
- Stocks generally offer the highest investment returns. They also have the largest potential downside.
- Bonds don’t typically perform as well as stocks do. However, they are often used to offset the risk of stocks.
- Cash is usually the safest asset class. That said, its returns rarely outpace inflation.
- Real estate can help provide long-term returns. Unfortunately, it is more difficult to buy and sell than the other asset classes.
BUT at WealthFit, we use Robert Kiyosaki’s 4 asset classes. They include small businesses, paper assets, commodities, and real estate. Kiyosaki’s asset classes expand upon the traditional asset classes.
You can invest in your own business or in somebody else’s business. Small businesses can provide some amazing returns. They also go belly-up much easier than the other asset classes. They’re much more difficult to invest in than traditional paper assets.
If you decide to invest in small businesses, you’re going to want to know what you’re getting into. It’s not enough to be interested in a project. You need a deep understanding of the project, the founders, the funding, and the overall business strategy in order to make a comfortable investment.
Paper assets include stocks, bonds, mutual funds, and cash. They can also include stock options, stock futures, retirement accounts, foreign exchange, and REITs. These are highly liquid investments. They usually don’t provide the same outsized returns smaller businesses do.
Commodities are assets like corn, soybeans, oil, gas, precious metals, and coal. You can buy and sell contracts to own these assets to diversify your holdings. Buying and selling them is more complex than traditional paper assets.
Real estate investments can provide returns in 2 ways: renting or flipping. Rental properties offer cash-flow where a flipped house might sell for a more immediate profit. Real estate investing often requires leveraging to maximize your returns.
You can mix these asset classes to create a portfolio that meets your needs.
How A Balanced Portfolio Helps You Make Your Money Last
So why should you try to have a balanced portfolio that matches your risk tolerance? The key is optimizing the performance of your portfolio while keeping your investment safe.
You could technically earn more money by investing in the best asset class year in and year out—but that would take some serious foresight on your part. Not even psychics have crystal balls that good.
Instead of leaving it to luck, you should feel comfortable with the upside risk. More importantly, you must be able to stomach the downside risk.
If you invest too aggressively and sell when an asset class drops beyond your comfort level, you lose out on the potential gains that asset class can provide you.
A balanced portfolio helps you find the investments that provide the maximum gain while managing your risk for potential loss. This can help prevent you from panic selling.
Without panic selling, you’re more likely to achieve the long-term gains your portfolio should offer you.
Rebalancing Is The Key to Making Your Money Last
Over time, certain asset classes will outperform. Others will under perform. This can disturb your ideal asset allocation. In fact, it will unbalance your ideal balanced portfolio.
You will not achieve your long-term gains if you don’t rebalance your portfolio.
Essentially, rebalancing is the act of selling asset classes that become too big a part of your portfolio. Then, you buy more of the asset classes that are underrepresented.
How your portfolio can become unbalanced
Let’s say your ideal balanced portfolio consists of 60 percent small businesses and 40 percent paper assets. One of your small business investments hits a home run and triples in value overnight.
This could tip the scales of your balanced portfolio.
Now, small businesses might make up 75 percent of your portfolio. Even though your paper asset value didn’t decrease, it now only makes up 25 percent of your portfolio. The same asset class risks still exist.
If you leave your portfolio alone, you’re now exposed to higher risk. That means it’s time to rebalance.
How to rebalance your portfolio
To rebalance your portfolio, you’ll have to sell asset classes when they’re doing well. You’ll also need to buy asset classes that aren’t doing well.
At face value, this might not seem like a good idea. In fact, it’s actually a great idea. It forces you to sell high and buy low, which is exactly what smart investors aim to do.
In the scenario above, this means you sell some of your small business investments. Then, you use that money to buy paper asset investments. Once you’re back to a 60/40 allocation, you are properly rebalanced.
Figuring out your ideal balanced portfolio helps you reduce your risk of making bad long-term investment decisions.
Rebalancing helps you continue to make smart decisions and grow your wealth.
The key is remembering to do both—even when things seem great. As always, you should consult with a financial adviser when making any investment decisions.
Lance Cothern is a WealthFit Contributor. He's a freelance writer and founder of the personal finance blog Money Manifesto. He also holds a Certified Public Accountant license in the Commonwealth of Virginia.