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Master the balancing act of investment growth

Turn losses into gains by juggling your stock and bond percentages. “Today” financial editor Jean Chatzky offers advice to investors.

Balancing doesn't just apply to your checkbook anymore. “Today” financial editor Jean Chatzky covers the basics of asset allocation and explains when and how to reassess your investments.

Q: Let's say you had an hour or two of free time. Which would you do?: a) Wash your windows or b) Rebalance your portfolio.

A new study of 1,000 investors conducted by Matthew Greenwald Associates for the folks at AllianceBernstein shows nearly half of all investors are more likely to do the former. Big mistake. Setting and then maintaining an asset allocation that insures you take the right amount of risk at the right time is one of the most important things you can do to insure you have enough money to retire. Not only can the right mix help you keep pace with the market in good times, it can protect you from big losses in bad.

But before we get into how to come up with that asset allocation, let me go over the basics. (If these terms are second nature to you, feel free to skip down a few graphs.)

  • Asset allocation is the act of splitting the money in your portfolio among different asset classes. Most people think in terms of three asset classes: stocks, bonds and cash or cash-like investments like money market funds which aren't subject to the risks of the market. I tend to think in terms of four, throwing in real estate for good measure. Frequently, you'll hear asset allocation mentioned in the same breath as diversification.
  • Diversification is what happens after you allocate your assets in these big buckets. Then you have to make sure that you have different kinds of stocks (growth and value, large company and small, international and domestic) and different kinds of bonds (high yield, corporate, government, maybe inflation protected).
  • Finally, there's rebalancing. The first time you go through this exercise in asset allocation you're going to come up with some numbers — maybe you'll decide to put 60 percent of your money in stocks, 30 percent in bonds and 10 percent in cash. The problem is, after you make those choices the stock market moves. If stocks go up (as we all hope they do) you could quickly end up with 65 percent in stocks and 25 percent in bonds by doing absolutely nothing. Rebalancing is when you sell some stocks and buy some bonds to bring those allocations back to your original balance.

It's not brain surgery, clearly. So what's the problem? Rebalancing may be a breeze from a technical perspective. But emotions can get in your way. “Even individuals who say they understand asset allocation and diversification also say they can't bring themselves to rebalance their portfolios,” says Marc Mayer, CEO of AllianceBernstein. “Rebalancing is counterintuitive. It means selling the things you have the greatest affinity for because they've been making you the most money, and buying those you have distaste for because they haven't been working.”

But it can make a huge difference. Research has shown time after time that individual investors underperform the stock market as a whole. The AllianceBernstein study (on which you can get information at says it's by 1.5 percent to 2 percent a year. Other studies have said it's by 7 percent to 10 percent. Trouble is: We're human. We hear about a great stock or a great sector, so we buy it ... after it's run up. We hold onto losing stocks or funds too long, because selling is admitting we made a mistake in our research. Our portfolios are constantly out of balance because we have too tough a time reigning them in.

So I'd like to suggest a solution — and it's one I've incorporated into my own life. Take yourself (and your emotions) out of the process. Mutual fund companies have in the last few years rolled out things called “life cycle funds,” “target date funds” and “asset allocation funds.” The first two (my preference) asks you what year you're planning to retire and then as it gets closer to that date, shrinks the percentage it has in stocks and boosts the percentage it has in bonds to reduce your risk over time. This way, if the stock market tanks a year or so before you're set to retire, you should still be OK.

The latter insures that you maintain a steady balance of, say, 60 percent stocks and 40 percent bonds (which is what most investors should have as they're actively saving and investing for retirement) but doesn't adjust with your age.

Similarly, some 401(k) plans have introduced management services. You pay a small percentage of assets and the plan manager rebalances on your behalf. I've taken them up on this offer.

Any of these is a great solution compared to doing what most people do: Nothing. Even a tiny difference in returns over the lifetime of your portfolio can make a huge difference. Take a person who, at age 25, earns $45,000 and increases that salary to $85,000 by age 65. Say he or she starts making 6 percent contributions to a 401(k) at 25, growing those contributions to an eventual 10 percent, and say those contributions are matched by 50 percent.

If he or she earns a conservative return on the money — 9 percent when young and taking more risk, 6 percent when older and taking less. Adding an extra 1 percent to his or her return over the lifetime of the 401(k) would mean an extra 10 years — at $64,000 a year — in money to spend during retirement. Notes Mayer: “That 1 percent, which proper asset allocation makes absolutely possible, is the difference between living well and living in worry.” Sounds like a pretty convincing argument to me.

Jean Chatzky is an editor-at-large at Money magazine and serves as AOL's official Money Coach. She is the personal finance editor for NBC's "Today" show and is also a columnist for Life magazine. She is the author of four books, including 2004's "Pay it Down! From Debt to Wealth on $10 a Day" (Portfolio). To find out more, visit her Web site, .