Simplifying Financial Terminology Part 3

Introduction

With new technologies come new terminology. Think “YOLO,” “swipe right,” and “life hack.” We consumers hope to catch on quickly so that we can understand and communicate across generations. However, when discussing finances or financial topics through websites, books, magazines, and television shows, there are many decades-old terms that haven’t been fully explained in the context of everyday life. This monthly series will explore some of these terms so that you can include them in your various life hacks.

Rebalancing, Diversification, and Risk

Our first term is rebalancing. Over time, your investments fluctuate in value and may need to be sold or bought in order to bring the allocation percentages in line with what you or your advisor feels is best based on multiple factors. Another term you may hear on commercials or read on websites is diversification. Diversification can be done at a very high level between cash, stocks, and bonds, as well as at more detailed levels that may include specific stock sectors or even specific countries to invest in. Our third word is risk. The concept of risk is nothing new in our everyday lives; e.g. the risk of getting burned by touching a hot stove or the risk of electrocuting yourself from a live wire. Within your investment portfolio, risk takes on multiple meanings based on your goals, time horizon, and ability to see account values change on a monthly or even daily basis.

Why these Terms are Important for You

While you may have heard of these phrases and words, you may not have seen them used in situations that affect you directly when it comes to your money and your investments. Rebalancing sounds simple enough (“lets just move the investments to how they were when we started”), but before you press that button, be aware of taxes. If the investment account is subject to capital gains taxes, you may be costing yourself as much as 40.8% of the gain in taxes for a married couple filing jointly for a recognized short-term capital gain. Rebalancing in tax-deferred accounts such as Individual Retirement Arrangements (IRA’s) or 401(k) accounts allow you to rebalance without incurring a capital gains tax on the rebalance.

If you have addressed tax consequences of rebalancing with your tax and investment advisors, the next question to answer is timing. When should you rebalance? Are you rebalancing on a monthly basis, quarterly basis, annual basis, when a position reaches a certain threshold, or just when you review the account? While timing can change according to movements in the investment markets, a consistent approach will allow you to maintain your desired investment allocation over a longer period of time. Your desired rebalancing time frame can be affected by your time commitment, your advisor’s time commitment, transaction costs, and taxes.

Ultimately, determining whether rebalancing is an appropriate strategy, or when rebalancing should occur, comes down to your goals. If your investment thesis calls for your portfolio to be a specific allocation to meet your goals, an appropriate rebalancing strategy should be created to make sure your portfolio maintains such allocations. Rebalancing strategies can incorporate using dividends to reallocate as well as using more than one type of account (taxable and tax-deferred) to pair investments that may generate more or less gains subject to taxes if sold.

Now that there’s a better understanding of rebalancing, we can identify how diversification can be used within your portfolio. Merriam-Webster defines diversification as “the act or practice of spreading investments among a variety of securities or classes of securities.” But what if you are investing in automakers because you believe the auto industry is poised for increased performance but don’t know which manufacturer will emerge as the winner so you decide to buy a collection of automakers to hedge your bet? Is that diversification or is it better to invest in a basket of automakers, airline companies, and pharmaceutical companies? The answer is “yes” to all of the above; however, it is crucial to ask why we are diversifying. Is it for specific exposure to a sector or industry or for broad exposure to an entire market?

Knowing why you are diversifying can be traced back to your goals. If your goals require you to obtain an 8% rate of return and you use one stock (assuming a 9% return) and one bond (assuming a 5%) return and each are worth 50% of the portfolio, you will not achieve your stated goal, but you will meet the definition of diversification. Working with your financial professional to identify your goals will allow you to build an investment strategy that can incorporate diversification while still positioning the portfolio to meet your objectives.

The reason diversification needs to be associated with your goals is mainly due to the risk associated with diversifying. If you put your entire portfolio into an index fund that tracks the S&P 500, you are diversifying across 500 different names but limit your exposure to smaller companies, international companies, and non-stock investments. While you are diversifying among the 500 largest companies, you are leaving out a majority of the investment universe. This might be okay given research time constraints or even access to certain investment markets but it is important to identify why you are diversifying and what your desired results are so you can create an investment plan that diversifies properly for you.

As we just discussed how risk is a part of diversification, it is important to take a step back and understand what risk is and how it is used within financial planning. In 2004, a Londoner named Ashley Revell sold all of his possessions and went to Las Vegas to put his entire life savings ($135,300) on red at the roulette table. The wheel spun and the ball landed on red and within 30 seconds he turned $135,300 into $270,600. He took a risk that if the ball didn’t land on red he would be at $0. A lot of people may say it isn’t worth the risk, but for Ashley, he could start over if he lost his savings because he didn’t have any debt. He could also move in with his parents and find a job. In his situation, the benefits of trying to double his money outweighed the risks of losing it all.

A situation or strategy is ultimately only risky if you don’t account for negative outcomes and worst-case scenarios. While wrestling a bear can definitely cause injury or even death, preparing for those risks—while still not preventing the worst case scenario—can allow you to take the risk initially. Investing in the stock or bond markets can be risky unless you prepare for negative situations. This can be done through researching what you are investing in, not putting all of your savings into a particular investment or group of investments, and understanding the time frame of when you need access to your money.

Shifting the risk is a tool that can be used in your everyday life as well as in your financial life. If you passed away prematurely, you would be forfeiting future earnings potential that could be in the millions. If you don’t have the millions of dollars already on hand, you may want someone else to be responsible for providing that money to your loved ones. This can be done through life insurance by paying a premium well below the death benefit and having a life insurance company take on the risk of giving you more of a benefit than you paid for. Instead of picking individual stocks within your portfolio, you can use a mutual fund where you rely on an investment manager to do the research and make the buy/sell decisions while you continue with your daily life. Shifting the risk to another person or company may be appropriate when you factor in time and cost.

Rebalancing, diversification, and risk are tools and strategies to be incorporated into your overall financial plan and strategy that should work in concert to prepare you for your financial future.