Rebalancing a Sample Portfolio

'Tis the season to ... rebalance your portfolio. Rebalancing, or cutting back on your strong-performing holdings and adding to those that haven't performed as well, is often prescribed as part of a year-end portfolio tuneup. But whether you conduct rebalancing at year-end or less frequently, it's a great way to reduce your portfolio's overall risk level and ensure that its current allocations are on track with your targets.

About a year ago, my colleague Christine Benz outlined six steps to rebalancing. In this week's column, let's look at how the rules of rebalancing would apply to a sample portfolio.

Start with a Diversified Portfolio
Let's say that on Jan. 1, 2002 (roughly five years ago) we allocated $100,000 to five funds in equal proportion ($20,000 each):  Selected American Shares (SLASX),  American Beacon International Plan  (AAIPX),  Pennsylvania Mutual (PENNX),  T. Rowe Price Real Estate (TRREX), and  PIMCO Total Return D . Although such a portfolio has a rather aggressive stock/bond mix with only 20% bond exposure and is a bit heavy in real estate, this is a reasonably well-rounded, long-term allocation containing some of our favorite funds in different categories. Selected American is a domestic large-cap fund, American Beacon International holds foreign large caps, Pennsylvania Mutual is a domestic small-cap fund from the Royce family, T. Rowe Price Real Estate owns real estate investment trusts (REITs), and PIMCO Total Return is an intermediate-term bond fund. You could easily assemble this portfolio or one similar to it at a discount brokerage with a fund supermarket.

The good news is that this portfolio, if left alone (that is, no additional purchases and sales), would be up 98% through November 2006. So we've nearly doubled our money to $198,000, assuming we held the fund in a tax-sheltered account, such as an IRA, and didn't pay taxes. Although that's a great return, any time your portfolio has had such a big move, it pays to take a look at the extent to which its allocation has strayed from your original targets. If it has, it's time to rebalance.

Where to Add
In the case of our sample portfolio, one of the first things we might notice is that the PIMCO fund, which is a bond fund, hasn't appreciated as much as most of the stock funds. It has a cumulative return of 29%, so the original $20,000 we allocated to it is now worth around $26,000. That represents a decent gain, but our bond fund is now only 13% of the new grand total, making our allocation 87% stocks/13% bonds.

If the stock market were to experience a downturn, it would be nice to have the portfolio back to 80/20, with less money exposed to a declining stock market. Rebalancing by selling some of the stock funds and adding to the bond fund would be an effective way to restore your portfolio to its target allocations.

In addition, Selected American Shares is also taking up a smaller share of the aggregate portfolio than we intended. The fund has appreciated around 50% to roughly $30,000, but it now occupies 15% of the portfolio. Its shrinking share of the portfolio makes sense because Selected American Shares is a domestic large-cap fund. The domestic large blue-chip stocks it tends to hold have been the worst performers over the past few years, still suffering from a hangover after their hard rally through the late 1990s. Thus, the fund has shrunk as a percentage of our aggregate portfolio, as our international, small-cap, and real estate funds have soared.

Where to Cut
So if we've decided to add to our positions in PIMCO Total Return and Selected American, the next step is to determine where the cash should come from, assuming we won't be using new assets to restore our portfolio holdings to their target allocations. If you're looking for funds to trim, your best performers will always be the best place to start. In other words, although our original $100,000 has nearly doubled to $198,000, our original $20,000 stake in real estate has tripled to around $62,000, encompassing 31% of the whole portfolio. Although I like real estate as a long-term portfolio diversifier, it would be difficult to justify that much real estate exposure under most circumstances and especially after the category has had such a powerful multiyear runup. A downturn in commercial real estate could do major damage to this portfolio.

Looking at the rest of the portfolio, we notice that the American Beacon International fund has returned 104%, occupying roughly the same amount of the portfolio as it did at the beginning of 2002. Pennsylvania Mutual similarly has returned 97%, retaining almost exactly its original percentage of the whole portfolio. So we'll leave both these funds as they are. I'd typically advise that investors only rebalance if their allocation to a given investment rises 10 percentage points or more above their targets.

Taking Action
So how would we get this portfolio back into sync with our original targets? To rebalance, all we'd have to do is shave around $22,000 off of the T. Rowe Price Real Estate Fund, and allocate $10,000 of it to Selected American and $12,000 of it to PIMCO Total Return. Taking $22,000 from T. Rowe Price Real Estate would get it down to roughly $40,000, which would be roughly 20% of the value of the whole portfolio. Adding $10,000 to Selected American Shares and $12,000 to PIMCO Total would also get them close to $40,000 or 20% of the portfolio.

Caveats
Pennsylvania Mutual won't be a No Transaction Fee fund at any fund supermarket, and the T. Rowe Price fund would most likely only be an NTF fund on T. Rowe Price's own brokerage platform. Although we didn't add to these funds in this exercise, purchasing shares of them could involve additional expenses. Moreover, shaving winners in a taxable account leads to capital gains taxes; keep in mind that it's much cheaper to rebalance your tax-sheltered accounts. Also, although it's not a good idea to avoid looking at your portfolio for years at a time, it's equally dangerous to tinker with it obsessively. Let powerful market moves that take your allocations 10 percentage points away from their targets dictate rebalancing. Make it a point to eyeball your allocation once or twice per year to monitor big swings.

Finally, besides being potentially overexposed to real estate and underexposed to domestic large caps, consider other categories that we didn't include in this allocation. For example, you may be overexposed to emerging-markets stocks and bonds, foreign small-cap stocks, and commodities, since those categories have done so well in recent years.