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Long-Term Investing: Portfolio Management, Compound Interest

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July 18, 2016
Broken plate: Review and redistribute your long-term investment portfolio regularly

Portfolio management is the ongoing maintenance of your long-term investment portfolio. It means reviewing your asset allocations, adding new money, reinvesting interest and dividends, managing risk by rebalancing, and maintaining a long-term perspective.

First things first: A long-term investor can use on the power of compound interest, which is interest earned on top of interest. Reinvesting can contribute to compound growth. The sooner money is put to work, the sooner it can start generating aa potential return and compounding. Let me emphasize that: it’s important to put money to work early.

The Eighth Wonder of the World

Figure 1 illustrates why it’s so important to put money to work sooner rather than later. Investor A began investing $20,000 in stocks at the beginning of 1996. After 10 years, Investor A stopped contributing to the portfolio, but allowed it to grow and compound for the next 10 years. The $20,000 investment grew to $55,639 by the end of 2015.

Investor B postponed investing for 10 years. At the beginning of 2006, Investor B began investing $2,000 each year in stocks for 10 years. The $20,000 investment of Investor B grew to $34,819 by year-end 2015. By starting early, Investor A accumulated $20,820 more than Investor B, while investing the same amount.

Compound interest at work

FIGURE 1: THE POWER OF COMPOUND INTEREST.

Data source: Stocks are represented by the Ibbotson® Large Company Stock Index. An investment cannot be made directly in an index. The data assumes reinvestment of income and does not account for taxes or transaction costs. Image source: Morningstar. For illustrative purposes only. Past performance does not guarantee future results.

A Rebalancing Act

Now that you’ve seen the power of compound interest, let’s talk about rebalancing a portfolio. Over time, assets like stocks or bonds grow at different rates. That means the investments may become improperly allocated—some will be overweighted or underweighted because they’ve grown faster or slower. That’s why it’s important to periodically rebalance a portfolio to maintain your target asset allocation.

Rebalance a portfolio regularly

FIGURE 2: THE IMPORTANCE OF REBALANCING.

Data source: Small stocks are represented by the Ibbotson® Small Company Stock Index. Large stocks are represented by the Ibbotson® Large Company Stock Index. Intermediate-term government bonds are represented by the five-year U.S. government bond. An investment cannot be made directly in an index. The data assumes reinvestment of income and does not account for taxes or transaction costs. Image source: Morningstar. For illustrative purposes only. Past performance does not guarantee future results.

At year-end 1995, the target allocation began with a 50% allocation to stocks and a 50% allocation to bonds. The stocks in the portfolio grew from 1995 to 2005, jumping up to 63% of the overall portfolio. This imbalance created higher risk in the portfolio, which translated to bigger fluctuations in its value. Subsequent market fluctuations caused the stock allocation to decrease to 60% by 2010 and increase again to 69% in 2015.

The important point is this: The allocation at the end of this period is drastically different from the 50/50 target portfolio allocation. And as the stock allocation increased, so did the risk of the overall portfolio.

Regular Review

How can an investor help keep this risk in check and maintain a long-term perspective? It’s simple: consider conducting a portfolio review each quarter and determine if you need to rebalance your portfolio. Rebalancing simply means selling part of an asset that’s become overweighted. Those funds are then added to an underweighted asset, restoring your target allocations.

Adding new money to a portfolio can also help address the risk if your asset allocations move away from your targets. For example, if you started with a 50% stock and 50% bond allocation, and it’s grown to 60% stocks and 40% bonds, you could direct new money to bonds. Over time, the bond allocation should grow and come back into alignment with your 50% stock and 50% bond target allocation.

In the end, portfolio management comes down to risk management and patience. Remember, compound interest is a big ally. Putting your money to work as soon as possible gives it more time to grow.

In the next part of this series, we’ll talk about how to put money to work and the importance of remaining invested through the ups and downs of the markets.

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