Rebalancing Your Net Worth Assets June 2014

This is the second article in a series on asset allocation and rebalancing. My first article introduced the concepts and focused on investment accounts, which hold financial or “paper” investments. The idea is that there are three primary asset classes: equities, fixed income and cash, and each of these three groups react differently to changing market conditions. An investor decides on a target percentage of his total investments to hold in each category, and then periodically rebalances investments as the actual percentage holding changes with shifts in the markets.

For example, if there is a strong bull market for equities and a weak market for bonds, then this would cause the actual percentage of equities in your portfolio to increase above your target. At rebalancing time you would sell equities and buy bonds to get back to your target percentages, in effect, forcing you to buy low and sell high.  Making this a mechanical process helps to remove the temptation to make trades based on emotional decisions and short-term market swings.

Though this concept works well for investment accounts, it can also be applied to assets other than paper investments. Using a set of “Net Worth Asset Categories” provides a clear overhead view of what and where your assets are. Setting targets for each of these categories can help you with general decision making in many aspects of your life and serve to highlight when you may be getting into a risky financial situation.

Net Worth Asset Categories

It has taken many years to come up with the categories which work for me and my family and the targets I have for each class have changed over time. Below are the categories I use and my current targets.

The categories are a way of seeing where your current assets are, but also identifying which of your assets produce income. Financial and retirement planning rests on the assumption that you are able to earn more money than you spend. If you work at a job and spend all that you earn, then you have limited options for improving your financial health. 

  On the other hand, spending less then you earn and investing your savings in assets that produce income, such as paper investments, rental real estate or business ventures, helps in three ways:

1. It increases your yearly earnings, which provides more money for you to invest in additional income-producing assets.

2. It diversifies your earning sources and capital.  Having a significant portion of my family’s net worth in physical real estate during the vicious 2008/9 market meltdown made it much easier to weather that storm. Or if you run your own business, having money invested in the financial markets can act as a cushion if your business runs into trouble.

3. Having your money spread across these categories truly can make your life more interesting.

Many of the items within these categories are, by their nature, not the sort of things you can easily rebalance in the short term, such as rental properties, vehicles and businesses. This makes minor rebalancing difficult if not impossible, but simply having a target set for these categories gives you something on which to base your day-to-day decisions. Even simply calculating what your current percentages are for these categories may be an enlightening experience. If you find the vast majority of your net worth is in the Other and Real Estate categories (which is likely the case for many Baby Boomers) then you may want to consider rebalancing and putting more money into investment accounts. If you have the vast majority of your net worth in a business and nothing else, you are entirely exposed to the fortunes of your venture, leaving you in a vulnerable situation if things turn sour.  Below is a brief discussion of each of the net worth asset categories.

Cash

On its own, cash generally doesn’t provide much return (especially in today’s low interest rate environment), but it sure is nice to have! During the most recent stock market crash, I remember reviewing my assets during the worst of the crisis, wishing that I had more cash available to invest in the smorgasbord of stocks that were “on sale.”  At the time, I hadn’t allocated much money to fixed income investment so I really didn’t have anything to sell to generate cash.

From time to time, opportunities will appear in the other asset categories and having cash available makes it easier to take advantage of them. For example, you may find somebody in some sort of financial distress who is liquidating his or her assets at below market value, or perhaps be offered a lucrative business opportunity. Cash makes all these things possible and also provides a certain sense of comfort.

Real Estate

Most Baby Boomers are intimately familiar with this category as they may be living in homes worth hundreds of thousands of dollars that they bought many years ago for a tiny fraction of that. The passion for real estate in Canada runs deep. Why? Probably because real estate is generally easy to understand and frighteningly simple to buy and sell. Many individuals will put more time and energy into researching which smart phone to buy than they do purchasing a house worth thousands of times more.

Real estate that you own and are able to rent can produce income. Examples include residential or commercial properties, vacation properties, farmland, or even the basement suite in your own home. And any of these can increase in value over time, which means a potential capital gain when you sell it. One unique quality of real estate is the ability to leverage it, which means you can borrow the vast majority of the money required to buy it, and pay it back over time. This serves to magnify your percentage gains or losses when you decide to sell.

The target percentages for real estate and all other asset categories are always calculated net of any liabilities. If you have rental property worth $300,000 but with a $200,000 mortgage, then the value of the asset is $100,000.

Businesses

Many people own and operate their own business, which produces the majority of their income. Others hold a regular job, but may have a business on the side.  Investing a portion of your money in a business can serve to diversify your earning streams and, if you are actively involved, give you an opportunity to use your skills to develop and grow the business, possibly setting yourself up for a nice future capital gain if you are able to sell it.  You may also choose to be a silent partner in a business where you front a certain percentage of the capital required then take a share of the earnings, but do not get actively involved.

Investment Accounts

Investment accounts hold your paper investments, such as stocks, ETFs and bonds. These are typically extremely liquid and can be bought and sold with the push of a button. They often produce income in the form of dividends, interest or capital gains and are often the cornerstone of one’s retirement assets. These can be managed for you by a financial advisor or by yourself if you are willing to invest some time in understanding the world of investing. And as a Canadian Moneysaver reader, you probably are!

Other

This category is for any other asset you own; these are often not income-producing and tend to depreciate over time. These could include vehicles, campers, boats, furniture, but also investment type assets which do not fit neatly into any other category, such as art, coins and that marvellous cellar of rare wines. Many of these are necessities of life while others may be strictly for recreation or personal enjoyment. Having a target in this category forces you to consider what percentage of your overall net assets are generally costing you money to own instead of paying you to own them.

Setting Targets

How does one come up with targets for each of these asset categories? There is no simple answer for this as it will depend entirely on your personal preferences and situation in life. The main goal is to take an objective view on what you own and how exposed you are to changes in the market and in the world. Having your entire net worth in the financial markets does expose you to the risks of a major Black Swan event (I am a huge Nassim Nicolas Taleb fan) that could potentially wipe you out. Alternatively, investing everything you own in highly leveraged real estate also puts you in a vulnerable, fragile position.  There are others still who spend everything they own on vehicles, boats and other “fun stuff ” and are building no savings of any sort for the future. To me, none of these situations is ideal, and by actually calculating where you sit in each category, it may become clear that a more balanced approach is required.

The Rebalancing Process

Rebalancing your net worth asset categories is not the same as the periodic rebalancing of paper investments as it is not as easy or fast to move money from one category to the other. This rebalancing is more of a gradual process and should be happening constantly as you are faced with life decisions. For example, let’s say you have been in the same house for many years and it has gone up in value substantially. You decide to downsize and are now in the fortunate position of having a large amount of cash available.  Where do you put it? Having target percentages in each category might help with this decision. 

These are the steps I use to rebalance my net worth asset categories:

1. Once every three years, I review my target percentages for each category and decide if any change is required based on my family’s stage of life, market conditions or any other events which may have changed and affected my goals.

2. Once per year I value all existing assets and calculate current actual percentage for all net worth categories

3. I compare actuals to targets for each category, mark each category as “Increase” or “Decrease,” and identify the approximate dollar amount I need to adjust holdings.

4. Look at any major changes that may be happening in the coming year, such as a potential property sale, required vehicle replacement, possible business opportunity, change of job or any other event that will affect your net worth, assets or earnings in some way.

5. Put a plan in place to deal with the upcoming transactions in such a way that you move closer toward your target percentages in each asset category.

Rebalancing your net worth asset categories is not as rigid or mechanical as rebalancing investment accounts, but it is a way to take an objective view of your financial health and can serve as a helpful guide for decisionmaking.

Kris Olson, B.Comm, DIY Investor, Traveler, Author of The Found Vagabond - Paris, ON, (519) 442-3020

kris@lifeisgrand.org,

www.lifeisgrand.org