Investment Balancing Act: Making sure you’re on the right track

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Most investors understand the importance of diversification—the concept of spreading your exposure over many investments to reduce the risk of any one investment. Equally important, and perhaps less understood, is the idea of asset allocation—constructing a portfolio with exposure to equities (U.S. and international), fixed income (bonds) and cash suitable to your individual goals, time horizon and feelings about risk.

Here’s the rub: Once you’ve got your portfolio in shape, things change. Markets move, obviously, and your situation can change. Either or both can have an impact on your asset allocation, and either or both can require rebalancing or reallocating. Market forces may necessitate rebalancing.

Here’s a simple example that highlights how market dynamics require a new balance. My hypothetical investor is a 44-year-old with $250,000 in her retirement account. With at least 15 years to go before retirement, she has a long-term time horizon. She also happens to be comfortable with risk, meaning she has a fairly aggressive but not unreasonable asset allocation—75 percent of her portfolio is invested in equities with the remaining 25 percent in bonds. In January, she decided to take a fresh look at her portfolio. The equity portion of her portfolio did quite well, posting an aggregate return of 15 percent, while the bond portion lost 5 percent. Her $250,000 portfolio had grown to $275,000. But that also meant that her asset allocation had changed. The equity portion of her portfolio now represented 78.4 percent of her portfolio and the fixed income was just 21.6 percent. Her portfolio was slightly overweighted to equities and underweighted to fixed income. To get back to her target allocation of 75 percent equity/25 percent fixed income, she would have to sell some of her equities and use the proceeds to add more fixed-income investments. She would be, in effect, selling high and buying low, precisely what you hope to do.

The analysis becomes a bit more complex when you start to add accounts (you may have multiple Individual Retirement Accounts, 401(k) plans or a taxable brokerage account) and begin to divvy up your portfolio pie into more slices. For example, large cap vs. small cap stocks or value vs. growth. But the principle remains the same: Once you’ve determined an appropriate asset allocation for your portfolio—and this is relatively easy to do using online tools or the guidance of an objective adviser—you should periodically re-evaluate your total exposure to stay in sync. You’ll probably want to do some periodic selling and buying to get things in line with your target.

If you do need to rebalance your portfolio, do it in the most tax-efficient way possible. For example, if you must take a loss, you’d rather do it in a taxable account where you can get the tax benefit. You can also rebalance without incurring taxable events; if you need to add equity exposure, direct new money into your stock funds rather than sell a position.

In general, evaluate your portfolio at least once a year, and consider “pruning” any asset class that’s outpaced its target by more than about 5 or 10 percent. When markets are moving dramatically, you may want to rebalance more often.