When it comes to investing, you hear a great deal about the importance of things like proper asset allocation, risk tolerance, time horizon, and automatic portfolio rebalancing. But what do these terms mean?
Asset allocation is a strategy that focuses on how your money is distributed among various investments, which include stocks and bonds, but also cash. You might see “…but also cash” and wonder, “How so?” As an example, when markets hit a downturn, some investors wonder if they should sell their equities and jump to cash, because cash is entirely “safe.” Correct? Over time, cash loses purchasing power, as we have all clearly seen with inflation over the last few years. But this is also true during periods of low inflation.
One thing we financial advisors have often been asked in the last year (it's a common question when the markets hit a rough stretch too) is, “Should I move to cash?” If you liquidate your investments and move to cash, you are not only going to lose considerable purchasing power over time due to inflation, but you are locking in those dreaded losses with the decline in the value of your stocks.
When it comes to the risks associated with an all-cash investment diet, an even simpler way to say it is that your cash is losing value if the rate of inflation exceeds the interest you are earning on your savings accounts (which is virtually a constant). This is why asset allocation is so important, and your asset allocation is going to be determined by your risk tolerance and your time horizon.
Your risk tolerance is the level of market volatility you are comfortable enduring as an investor. Can you comfortably tolerate risk, including the stress of normal fluctuations in the market – and even losses that, ideally, only occur over the short term – for the possibility of larger gains in the long term? Identifying your tolerance for loss is one of the foundational aspects for determining the investment allocation your advisor will recommend for you. In part, your advisor does this by familiarizing themself with your overall financial situation, and then by helping you to identify your tolerances. In this way, a qualified, fiduciary advisor helps keep an investor from making emotional or uninformed financial decisions about money. This is one of the most important things an advisor does.
In financial terms, a time horizon is the duration that an investor intends to hold a particular investment until they will need that money. Time horizons are predicated on a pilot’s individual financial goals, but we most often associate them with retirement dates. (Yet, they can also be contingent upon large purchases such as buying a new house.)
One of the primary ways in which a pilot’s risk tolerance and time horizon impact one another typically has to do with a pilot’s age. That is, the closer a pilot is to retirement, the shorter their time horizon (when they will need the money). And typically, the shorter an individual’s time horizon, the more conservative their investment risk tolerance becomes, because there is less time left to work and save, and recover from downturns in the market. This is why it is so common for investors to rein in their risk tolerances as they get older.
Automatic rebalancing is when your investments are adjusted to keep your money in alignment with your allocation elections and preferences. But why does this need to happen? For example, let’s say you have saved well and are a fairly conservative investor who wants to retire in a few years. You and your advisor have selected a model portfolio that allocates $1,000,000 of your savings evenly between stocks and bonds. That is a 50/50 stock-to-bond allocation and that is what you are comfortable with. But for the sake of the example, let’s say that over a year, the markets rise to new highs, outperform all expectations, and now your investment allocation (the money you have invested) is now distributed at 65% to stocks and 35% to bonds (because the stocks percentage formerly at 50% has grown).
While the increase in the value of your stock allocation is certainly nice, your portfolio has moved away from its targeted mix, which, remember, was chosen partly based on your risk tolerance level. Now you are substantially over-exposed with stocks, while the bond portion of your portfolio (which may have grown in value, as well) is substantially underweight. (And note, that your investment allocation can stray from your ideal mix and balance and become under- or overweight due to declines in your investments, as well.)
Automatic rebalancing is the systematic reallocation of your portfolio to bring your investment elections back in line with your risk tolerance and time horizon. This is a key part of investment management. In short, automatic rebalancing acts as a counterbalancing instrument, which in a sense is you “buying low and selling high.” This is but one key safeguard that helps protect you from the possibility of incurring a loss from which you might not have time to recover.
While there are of course many other factors, and while the above doesn’t take into consideration significant aspects of building a portfolio – such as how we measure a particular investment’s risk – allocation, tolerances, time horizons, and automatic rebalancing are but four integral mechanisms we braid together to help you reach your financial goals.
With more than 40 years serving the airline community, RAA advisors understand the unique needs of pilots, crewmembers, and their families. We have a comprehensive planning approach to both partner with and guide you through the most important financial decisions of your life. Learn more and request a complimentary call with an RAA advisor today at raa.com/consultation.