Rebalancing made simple.
By Christine Benz | 02-01-05 | 06:00 AM | Email Article

Let's face it: Investing well requires you to get your head around some pretty counterintuitive concepts. Strong past performance rarely predicts strong future performance. Rising interest rates, a boon to those shopping for new certificates of deposit and other short-term savings accounts, are actually bad news for most bond funds. And for those of us consumers schooled in the maxim that "you get what you pay for" (there's a good bet a BMW is a better car than a Kia, after all), it may be hard to comprehend that the cheapest mutual funds are usually the best performers.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

Similarly off-putting is the concept that you improve your portfolio's overall risk/reward profile if you regularly reduce your holdings in those investments that have performed best while sending more to your laggards. Although counterintuitive, this practice, called rebalancing, is straight out of Investing 101--the importance of buying low and selling high. That's because when you rebalance, you put money into those securities that have held steady or dropped in value (your losers) while paring back on those investments that have grown more expensive (your winners).

To illustrate the merits of rebalancing, financial writers often hark back to the second half of the 1990s, when risky tech shares consumed a disproportionate share of many investors' portfolios. When the tech market sank, so did their portfolios. That's not apt to be a risk for most investors right now; many of you learned, the hard way, the risk of loading up on a single risky sector. But the market trends of the past five years have still been quite pronounced, with bonds trumping stocks and small caps beating large. If you haven't actively cut back on your winners recently--or perhaps you lightened up on stocks during the bear market and never fully got back in--it's possible that your portfolio is out of sync with where it needs to be.

Here's how to find out if your portfolio needs a tuneup, as well as the steps you should take to get the job done.

1) Find Out Where You Are Now
Okay, regular readers--get ready. I'm about to sing the praises of Morningstar's Instant X-Ray tool. Again. But the fact is, if you're tackling any task at the portfolio level, you need to be able to look at all of your accounts--your 401(k) and that of your spouse, your IRAs, and any taxable accounts that you hold, including cash holdings--as a unified whole. Instant X-Ray helps you get the job done.

To use X-Ray, simply enter the tickers for each of your holdings and your holding amount, then click "Show Instant X-Ray." You'll not only see your portfolio's breakdown among stocks, bonds, and cash, but you'll also see how it shakes out across Morningstar's investment style box and view how your sector weightings compare with those of the S&P 500 Index. Before closing out of your X-Rayed portfolio, click "Save Instant X-Ray Holdings as a Portfolio." Follow the prompts and name your portfolio--you'll need to refer back to it later.

2) Find Out Where You Need to Be
To determine whether you need to make any changes to your current mix, it's essential that you have an idea of how much you should have in stocks, bonds, and cash given your goals, time horizon, and savings rate. Bear in mind that your optimal stock/bond/cash mix--or asset allocation--will be a moving target, as most of us need to tilt our portfolios toward conservative investments as we get closer to retirement or any other savings goals. If you haven't revisited your own asset allocation in a few years, it's a good idea to do so before you undertake any rebalancing.

To help simplify the task, check out Morningstar's  Asset Allocator tool. (Asset Allocator is available to's Premium subscribers; for a free trial subscription click here.)

3) Compare Your Target Allocations with Where You Are Now
Now it's time to evaluate if you need to make any changes. Start with your current asset allocation. Is it dramatically out of whack with your targets? I wouldn't get too worked up about minor divergences--if your stock weighting is, say, 2 percentage points less than your optimal allocation, you probably don't need to make any changes at all. (The most successful investors are usually those who trade the least, particularly where taxable accounts are concerned.) But if your current allocations differ from your target allocations by 5 percentage points or more, that's something you'll want to address.

4) Be on the Lookout for Investment-Style Bets
Secondarily, you'll want to size up whether your portfolio's fortunes are riding on certain parts of the market. Using Instant X-Ray again, check out your portfolio's sector positioning relative to the S&P 500 Index. Are you heavy on tech shares? Financial stocks? Again, we're looking for big inadvertent bets here. If your portfolio is heavily tilted toward a given sector and you're comfortable with that positioning, fine. Just know what types of bets you're making.

While you're at it, check out your portfolio's positioning in Morningstar's style box; after a five-year runup in smaller-cap value stocks, you may find your portfolio is skewed toward the lower left-hand corner of the style grid. As a reference point, compare your portfolio's style-box positioning with that of the Wilshire 5000 Index (as represented by  Vanguard Total Stock Market Index ). As of the end of September, that fund had 22% of its assets in large-value stocks, 29% in large-blend stocks, 20% in large-growth stocks, 6% in mid-value stocks, 7% in mid-blend stocks, 6% in mid-growth stocks, and 3% in each of the small-cap boxes. I'm not saying that your portfolio needs to be a mirror image of the index, mind you. Instead, you're looking for big scary bets you didn't know you were making.

5) Tinker, Starting with Your Tax-Sheltered Accounts
If your portfolio is in line with your target asset allocation and you're not making any inadvertent sector or style bets, your work is done. But if you determine you need to make some changes, you'll want to go back to your saved portfolio and do some tinkering.

In some cases, the alterations you need to make might be obvious--if you're heavy on bonds, for example, trimming your bond funds should resolve the problem. Getting to the bottom of other bets might take a little more research. For example, if your portfolio has more cash than you want it to, that could be because one of your stock-fund managers is holding a lot of cash. You could decide to live with it, and reduce your designated cash holdings accordingly, or else pare back your holdings in the cash-heavy stock fund.

Rebalancing often requires that you sell, so it's essential that you focus your rebalancing efforts on your tax-sheltered accounts to reduce tax costs. If you need to sell, do so in your IRA or 401(k), if at all possible. Alternatively, you could try to correct your portfolio's imbalances not by selling but by directing a bigger share of future contributions to those holdings that need beefing up. In so doing, you'll save on tax and transaction costs.

6) Plan to Make a Habit of It
Conventional wisdom holds that there are two ways to rebalance--either you can rebalance on a set schedule, say, every December, or you can rebalance whenever your portfolio gets dramatically out of whack with your targets.

My advice is to split the difference. While I think it makes sense to give your portfolio a thorough review once a year, you don't want to get into the habit of trading too frequently. Schedule a top-to-bottom portfolio review at a fixed time each year. (My colleague Gregg Wolper noted in a recent column that the holiday crunch time--which many pundits recommend for rebalancing--may actually be less than ideal). But rebalance only if your portfolio's allocations have gotten dramatically out of whack with your targets.

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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