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Investing Specialists

Rebalancing Made Simple

Your step-by-step guide to restoring your asset allocation.

If you've put off rebalancing because the process seems daunting to you, read on. The following step-by-step guide simplifies the process using tools on Morningstar.com.

Step 1: Determine your asset-allocation targets.
Your first step in the rebalancing process is to make sure you have an asset-allocation framework. If you had a stock/bond target that made sense for you before the recent market downturn, it should still fit now. And if you don't have an asset-allocation plan, it's time to make sure you have one. My favorite "quick and dirty" method of getting in the right asset-allocation ballpark is to look at the asset allocations of target-date mutual funds geared toward individuals in your age range. Of course, there are no one-size-fits-all asset-allocation solutions--none of us knows how long we'll live, for one thing. These funds also vary widely in their asset allocations and in their overall quality. But I still think the stock/bond mixes of the Vanguard Target (middle-of-the-road asset allocations) and T. Rowe Price Retirement funds (more aggressive asset allocations) can be a good starting point for your asset-allocation framework.

The Web is also full of tools and questionnaires to help you with asset allocation. Morningstar's  Asset Allocator tool, part of our Premium service, is one way to help optimize your asset mix. If you have a portfolio in Morningstar.com's Portfolio Manager (more on this in Step 2), the tool helps you find the best combination of holdings to meet your goals.

Step 2: Find your current asset allocation.
After you've determined what your optimal asset allocation should be, it's time to take a look at where you are now. If you're like many people, you may have been moving your investment statements directly from the mailbox to your desk drawer, afraid to glimpse how much money you've lost. But it's time to pull all of those statements out and take a look, or go online for an even more current view of your portfolio. Focus not so much on your recent losses, but instead take note of your current asset allocation.

Keeping track of your portfolio's asset allocation by hand can be a bit cumbersome and inexact, particularly because most mutual funds aren't pure stock or bond. It's not uncommon for stock funds to hold double-digit cash stakes, for example. For the clearest possible read on your asset allocation, I recommend Morningstar.com's X-Ray tools, which drill into each of your fund holdings to determine how they're allocated by asset class and investment style. If you store a Transaction portfolio on Morningstar.com, simply click on the X-Ray tab view within Portfolio Manager to see your current split among cash, U.S. and foreign stocks, bonds, and other. The X-Ray tab also depicts how your holdings are dispersed across the Morningstar Style Box.

If you haven't yet stored your portfolio on Morningstar.com, click on the free Instant X-Ray tool, found on the Tools cover page of Morningstar.com. Once in Instant X-Ray, enter the ticker for each of your holdings as well as the dollar amount you hold in each. Then click Show Instant X-Ray for your asset allocation. (If you want to refer back on this portfolio, click Save Instant X-Ray Holdings as a Portfolio, then follow the prompts.) Take note of your current asset allocation and compare that with your asset-allocation targets in Step 1. Determine where you need to add and subtract to restore your portfolio to your target levels.

Step 3: Identify candidates for tax-loss selling.
Before you begin altering your portfolio to put your asset allocation back in line with your targets, you also want to scout around for tax-loss candidates that you hold in your taxable accounts. I discussed the how and the why of tax-loss selling in-depth in two earlier columns, and this column discusses whether it makes sense to realize a loss in your IRA. If you're like most people, you won't have to look too hard to identify securities that are now priced more cheaply than what you paid for them.

Step 4: Formulate a rebalancing plan.
If your portfolio is in line with your target asset allocation and you're not making any inadvertent style or sector bets, your work is done.

Most likely, however, your analysis of your current asset allocation versus your targets indicates that your portfolio is light on stocks. At the same time, the securities that you've identified for tax-loss selling are also likely to be stocks and stock funds. If you're in the market for high-quality stock funds to consider for your portfolio, check out our list of  Fund Analyst Picks. If individual stocks are part of your portfolio plan, Premium users can screen for those companies with high star ratings.

When it comes to deciding which securities to add, as well as how much to add to each, you'll probably find that the process of overhauling your portfolio is a matter of trial and error. Here again, I'd recommend Morningstar's Instant X-Ray tool to help you evaluate the impact of various holdings on your asset-allocation mix before you decide to buy. Also, pay attention to the impact that various holdings have on your style-box positioning and sector weightings. Your stock portfolio doesn't need to be an exact clone of the broad market, but you should at least be aware of whether your portfolio is skewing heavily to one style or sector.

In some cases, the alterations you need to make are obvious--if you're heavy on bonds, for example, adding to stocks 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.

It also pays to consider tax consequences when rebalancing. Conventional wisdom holds that you should concentrate your rebalancing efforts in your tax-sheltered accounts, because you won't have to pay capital gains tax if you determine you need to sell shares. That advice may be less relevant this year, given that many of  your taxable holdings are well in the red and you won't face tax consequences if you need to unload something. 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.

Step 5: Plan to make a habit of it.
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, but rebalance only if your portfolio's allocations have gotten dramatically out of whack with your targets.

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Publishes January 2010