Best Advice for Overhauling a Portfolio

We're kicking off a Portfolio Makeover Week on Morningstar.com Monday, May 16. Because many Morningstar.com users have undertaken substantial portfolio changes over the years, and many others tinker with their portfolios on an ongoing basis, I wanted to harness your collective wisdom on the topic. What advice do you have for other investors who are making changes to their portfolios? What pitfalls should others be sure to avoid?

I recently posed those questions on the Portfolio Design/Management forum of Morningstar's Discuss boards. A collegial--and helpful--discussion ensued, with users swapping war stories and discussing lessons learned. To read the complete thread, or add a tip or two of your own, click here.

Not All Change Is Good Change
Several posters opined about the risk of getting buffeted around by market winds or short-term underperformance, noting that some soul-searching is invariably in order before making changes to a portfolio.

TOOOINTENSE shared some questions to ask, writing, "The first issue to address is why you feel an overhaul is necessary. If the portfolio has been underperforming, find out why. Is it because of fee structures in the funds? Would a shift to exchange-traded funds using the same investment theme clear up the problem? Is your aversion to 'risk' keeping you in an underperforming class of asset? Do you need to readjust your thinking as to what the real risk to your investment plan might be?"

BMWLover agreed that it's important to take it slowly and tune out the noise. "Don't react to what the market is doing. By the time you react you've missed the boat. If you're unhappy with your long-term strategy, then take your time and think things through. Think about your investment goals and then create a portfolio that targets those goals. Each time you change your strategy and restructure your portfolio the only ones that you are making rich are your brokers."

If you can't find a way to tune out short-term noise, several users shared a practical suggestion for making sure an urge to trade doesn't undermine your financial well-being: Set up a so-called mad money" account that's separate from the bulk of your portfolio. VGMontana advised, "Take 15% of your money and play with your emerging markets, foreign debt, commodities, gold, real estate and try to time the market if you like. At least 85% of your retirement will be on auto-pilot, and you won't screw that part up!"

Danahan learned from experiences the cost of too active trading and figured out a workaround. "One of the hazards I experienced as a hands-on investor was the urge to play with my mutual fund portfolio. It seemed I couldn't go more than a few weeks without buying or selling something, often with little effect either way. So a while back I set up a low five-figure account exclusively for individual stocks and ETFs. The first play was  Apple (AAPL), followed by  iShares Silver Trust (SLV) (oops),  Procter & Gamble (PG),  iShares Global Health (IXJ), and some others that have since come and gone. My only self-imposed rule is a maximum of 50 shares per purchase. As the account grows, so shall the ceiling. This way, I get my transaction fix without risking damage (and fees) to my core retirement portfolio, which shouldn't require an overhaul as long as I leave it alone."

Get a Plan
Other users noted that the ideal way to make sure your worst instincts don't get the better of you is to make sure you have a well-thought-out plan, including a sensible asset-allocation framework, before embarking on any changes.

Molokoeo's common-sense advice provides a worthwhile starting point. "Have a written plan, starting with a measurable objective. Be specific, avoid boilerplate cliches, and include your risk tolerance (volatility, for most of us). Do this yourself. Don't accept a one-size-fits-all plan written by and for someone else.

• Diversify globally across asset classes and keep individual positions small. Something will blow up, and you don't want it to devastate your portfolio.
• Know what you own and why you own it.
• Keep it simple. The explosion of niche ETFs, absolute-return funds, and leveraged this and that is seductive and dangerous. Remember when your mother told you, 'Just because all the other kids are doing something...?' She was right.
• Keep your expenses low. They'll eat up a significant portion of return over time.
• If you use a financial advisor, find one whose goals align with yours. Challenge him/her and don't follow anyone's advice blindly. No one cares more about your money than you do."

Racqueteer also emphasized the importance of crafting a broader strategy that dovetails with your risk tolerance and what you're trying to achieve. "The hardest step is to realistically assess one's risk tolerance--maybe more accurately expressed as one's loss tolerance. Then create an asset allocation that encompasses a broad diversification of assets within the context of that risk tolerance. If you can get those first two steps down, you're probably 90% of the way home."

Poster Dragonpat, through a bit of research and a bit of good fortune, also hit on the importance of diversification and finding a good balance between more aggressive and conservative investments. "[In November 1999] I had an all-stock portfolio up until then, spread all over (including the dot.coms). I decided I needed bond funds and value-stock funds, and I transferred all my money in my taxable and my 401(k) accounts into value and bond mutual funds. This is just about the luckiest or smartest thing I have ever done. Each person himself has to come to grips with risk and reward aspects of his investments, and make his own decisions on what to do about it. Sometimes an overhaul becomes necessary not because of what is going on in the market but because of what is going on in your life and changes in your ability to take on risk and changes in what you decide you want out of life."

Stuart kane shared a similar story about the importance of asset allocation, writing, "I've changed my asset allocation during the last several years as the market has improved so that I have a portfolio (hopefully!) that's less volatile. Going into the market crash, my allocation was approximately 80% equities and 20% bonds (the latter included about 5% money market). The equities were a combination of individual stocks and funds. So, for example, as individual stocks like  International Business Machines (IBM) and  Intel (INTC) recovered, I sold them and put that money in bond funds like  Vanguard's Short-Term Investment-Grade (VFSTX),  Weitz Short-Intermediate Income (WEFIX), and  Fidelity Floating Point High Income (FFRHX). Currently, my portfolio is about 50%-50% of stocks/bonds which seems about right as my wife and I are in our early 50s."

Rebalancing Rules
Several posters noted that once you have a sensible asset-allocation plan up and running, changes should only be necessary when it's time to rebalance.

Poster Rossinator, clearly speaking from experience, wrote, "Don't be reluctant to rebalance, especially when it comes time to take profits. I have been slow to recognize gains, and it has invariably led to taking smaller gains."

Kalamazookid shared this strategy: "I have never made a major makeover, but rather periodic re-evaluation of funds' roles, performance, and Morningstar ratings. I do not rebalance on a set time table but rather based upon market and economic conditions. In my opinion, if you tweak your portfolio once or twice a year you can avoid a major overhaul and [avoid] making such an overhaul at the worst possible time."

Have You Finished Your Homework?
One other oft-repeated piece of advice was to get educated and conduct thorough due diligence before making substantive changes to a portfolio. Of the several users who were most emphatic about this point, many noted that they are also avid users of online resources, such as Morningstar.com's Portfolio Manager, for tracking what they have and determining whether it's it time to make adjustments.

In a particular eloquent post (one that you should read in its entirety) that details a portfolio overhaul from start to finish, MountainMan talked about gaining confidence in his investment acumen by being a virtual sponge of information: "I interviewed friends about their investment approaches; I read articles and magazines they gave me. I consulted with an expert who was teaching finance classes at our local library, and I looked at model portfolios in Smart Money, Kiplingers, and at Morningstar.com. I now have a head full of information. You want tips? Take your time, do the homework and analysis, ask for help, and use the resources of Morningstar. You'll figure it out."

Gombey also enthused about the virtues of continuous learning. "Being successful in my day job was generally a passion for the work, education in the complexities, and soundly executed decisions over many years. By following investing forums (such as with Bogleheads, Morningstar, and Schwab), analyzing successful mutual fund allocations, and watching the Morningstar briefings a few days a week, I cover the passion and education areas."

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