Last week, I mentioned that I’ve begun the process of rebalancing my investment portfolio. When I opened my accounts with Fidelity Investments in 2009, I chose an asset allocation (though I can’t remember why). Because my investments have grown over the past two years, and because I think some of my former choices are goofy, I need to move some money around.

Right now, my investments are allocated like this:

  • 5.08% in Fidelity Canada (FICDX)
  • 5.41% in Fidelity Latin America (FLATX)
  • 9.45% in Fidelity Spartan International Index (FSIIX)
  • 11.69% in Fidelity Spartan Extended Market Index (FSEMX)
  • 18.16% in Fidelity Select Energy (FSENX)
  • 5.28% in Fidelity Real Estate Income (FRIFX)
  • 7.55% in Fidelity Four-in-One Index (FFNOX)
  • 37.39% in various bonds and bond funds

I’m on a quest to find an asset allocation that makes more sense for me. When I do, I’ll rebalance my portfolio.

Meeting with Fidelity
Once I decided it was time to rebalance my portfolio, I made an appointment with my contact at Fidelity. About ten days ago, he and I spent an hour going over my investments.

My contact — let’s call him Greg — is very careful not to give me investment advice. (I think perhaps he’s not allowed.) Instead, he asks me leading questions. He’s almost like an investment psychologist. He wants me to think about why I’m making certain choices. (I really like this, and it’s one of the reasons I haven’t switched from Fidelity.)

For instance, the first thing Greg did last week was to print out a chart of my asset allocation. “Does anything seem strange about this?” he asked.

“Well, it is a little odd that I have more than 18% of my portfolio in energy stocks,” I said. “That seems crazy.”

Greg kept a poker face. “Some might call it…imprudent,” he said. “If you think asset allocation is important, you have to follow it. You can’t be circumventing it by dumping 18% into energy stocks.”

I had a copy of Your Money: The Missing Manual with me. (I carry it with me all the time. It’s a constant reference.) Greg pointed to it. “What kind of investments do you recommend in your book?” he asked.

“Well, I like index funds,” I said. “They have low costs and good returns over the long term.”

“And how much of your portfolio is index funds now?” he asked.

I did some quick math. “Uh? 20%? 30%?” I said. Greg and I spent the next hour discussing how some of my choices were circumventing my stated goals. “Sometimes,” I said, “there’s what I know I should do, and then there’s what I’m actually doing.”

Greg and I talked about diversification. We talked about whether it’s a good idea for me to have so much invested in bonds. (I want to put my age in bonds — so, 42% right now.) Greg asked me to think about why I’m picking this number.

Greg pointed out that if I’m being conservative with so much of my money, then I need to be more aggressive with the rest of it if I want to meet my goal of retiring early. “Think of your money in bonds as the cash you’ll need early in your retirement — in ten years, maybe — and the money in stocks as the money you’ll need later in retirement,” he said.

Greg also helped me to see the tax consequences of rebalancing. I can do some rebalancing by contributing new money. But some of it’s going to have to come from selling gainers and buying losers. This not only incurs transaction costs; it will also spark long-term capital gains taxes. (I know that I shouldn’t make investment decisions based on taxes, but it still hurts, you know?)

In the end, Greg and I agreed to meet again on May 2nd. At that time, I hope to have a plan. And I hope to use that plan to develop a new asset allocation.

Mental accounting
After meeting with Greg, I went home and began to read. All last week, while I should have been writing about money, I was reading about it instead. I re-read bits of The Four Pillars of Investing [my review]. I scanned The Quiet Millionaire [my review]. I brushed up on Fail-Safe Investing [my review].

I also read my own advice on asset allocation and rebalancing. I thought about what my goals are and how I want my investments to help me reach them. I played with asset allocation calculators online.

In order to retire early, I have to be moderately aggressive with my investments. But — and this is where things get complicated — my secondary goal is capital preservation. I don’t want to lose money. In other words, like most investors, I want to get big returns without any risk of loss. Fat chance.

The only way to reconcile these two conflicting goals is through mental accounting, the process of framing funds as belonging in different buckets even though they’re all a part of one large pile. For me, that means:

  • I’m designating one bucket as my “safe” bucket. This bucket contains money I’m unwilling to lose. Its size is my age (or 42%). My goal for the money in this bucket is to preserve it.

  • The other bucket — which therefor contains 58% of my funds — is designated for aggressive growth. I’m willing to take calculated risks with this money because I want it to grow quickly.

Now that I have that mental model in place, I need to decide what to put in each bucket. Actually, the “safe” bucket is fine. I’m happy with the bonds and bond funds I have. I just need to make sure the bucket contains the right amount of them. It’s the stock bucket that I need to tinker with.

Walking through the numbers with Will
Last week, I had lunch with my friend Will. Will has been working in the investment industry for almost a decade, and he’s studying to be a financial planner. He knows a lot about asset allocation and investing. He asked me about my investments.

“Well,” I said, rummaging in my backpack, “I just happen to have a bunch of notes with me.” I knew Will would ask me about my investments, so I’d come prepared.

I showed him my current asset allocation. I told him about my goals, and described how I’ve mentally divided my money into two buckets. He wasn’t enthused about this. “A lot of people think like that,” he said, “but it’s not necessarily a good idea. Really, you just have one big pool of money, right?”

“Right,” I said.

“If you split your money into two smaller pools, you have to treat each one as if it were your only account. That means you’re duplicating effort by having to do some things twice.”

Like Greg at Fidelity, Will asked me a lot of questions about the funds I owned. He wanted to know why I owned each one. Unlike Greg at Fidelity, Will wasn’t shy about letting me know some of my choices were stupid. Especially putting 18% into energy stocks.

After lunch, Will had me take an on-line risk tolerance profile. I scored a 59, which apparently means my risk tolerance is greater than 80% of the population at large. This means I’m comfortable taking some calculated risks: I’m willing to invest in a stock or fund that offers potentially large returns, even though there’s also a greater potential for losses.

Mulling it over
After meeting with Greg from Fidelity, after having lunch with Will, and after reading all about asset allocation and rebalancing, I still hadn’t made any decisions. I’m mulling things over.

I’ve decided to read one last book about investing: David Swensen’s Unconventional Success, which is a highly-regarded manual for individual investors. Swensen suggests a target asset allocation for the average person, and he lays out the logic behind it. I’m leaning toward using this as a base to build upon.

By next week, I’m supposed to have my target asset allocation in place so that Greg and I can begin the process of rebalancing. Once I’ve made some decisions, I’ll report back to Get Rich Slowly to share where I’m moving my money and why. Stay tuned!

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