The Error-Proof Portfolio: 5 Tips for a Busy Rebalancing Season

In many years, rebalancing your portfolio--shifting out of asset classes and securities that have done well and into those that have underperformed--isn't a must-do. Portfolios' overall asset allocations just don't move around that much on a year-to-year basis. According to the redoubtable Bogleheads website, you'd need a 4% move in stocks to shift the balance of a 50/50 stock/bond portfolio up or down by 1 percentage point. Meanwhile, portfolios that skew more heavily toward stocks or bonds would experience even smaller asset-allocation adjustments.

Yet, the past five years have featured extremely robust returns for stocks, with equities posting double-digit gains in every year but 2011. Bonds, meanwhile, have experienced far smaller gains. A hands-off investor with a 50% stock/50% bond portfolio in late 2008 would now be the proud owner of a 60.4% equity/39.6% bond portfolio. Given that you achieve your best risk/reward profile by rebalancing when your portfolio veers 5 or 10 percentage points from your targets, rebalancing belongs on many investors' to-do lists right now. 

Here are some tips to help you get it done.

Tip 1: Assess asset allocation across multiple asset pools.
If you have multiple pools of money earmarked for a specific goal--such as your and your spouse's IRAs, company retirement plans, and taxable accounts geared toward retirement--the starting point for the rebalancing process is to survey the asset allocation of that combined portfolio. Unless you're getting ready for retirement and starting to think about sequencing withdrawals, the asset allocation of those individual portfolios doesn't matter nearly as much as the unified whole. Morningstar's X-Ray functionality, found in our Instant X-Ray and in Portfolio Manager tools, makes quick work of assessing the total combined portfolio's weightings. Even if you have each of your subportfolios stored separately on Morningstar.com, you can use the "Combine" feature in Portfolio Manager to set up a unified portfolio, which you can, in turn, X-Ray.

One note: If your portfolio includes actively managed funds, be careful about using X-Ray's "Cash" weighting to assess your liquid assets. Managers' cash holdings will tend to overstate your actual liquid funds. 

Tip 2: Address asset-class/sub-asset-class weightings all at once.
Discussions about rebalancing typically center around righting the portfolio's allocation to the big three: stocks, bonds, and cash. And it's true that those exposures will tend to be the biggest determinants of your portfolio's risk/reward profile. However, suballocations can get out of whack, too, so it pays to address your Morningstar Style Box, sector, and geographic exposures at the same time you adjust your overarching asset allocations. Equity portfolios are apt to include outsized exposure to small- and mid-cap stocks right now, for example, and may also skew toward U.S. names and away from foreign. If you need to lighten up on equities anyway, trimming smaller domestic names are probably a good place to start. And if you're redeploying money into bonds at this juncture, it's likely that your higher-quality bonds have lost ground to lower-quality, credit-sensitive bonds. Thus, the former could use topping up. 

The X-Ray function includes the S&P 500 as a benchmark for sector exposure. As a point of reference for style-box exposure, total market index funds currently have roughly 25% in each of the large-cap squares, 6% in each of the mid-cap squares, and 3% apiece in the small-cap squares. Meanwhile, the U.S. market currently accounts for about 45% of the globe's market value, though a big home-country bias isn't unreasonable for U.S. residents, as outlined in this video. 

Tip 3: Keep tax efficiency in mind.
Because it may involve lightening up on appreciated holdings, rebalancing has the potential to trigger tax costs that can erode the benefits of your changes. Thus, if any selling is in order, your best bet is to concentrate your changes in your tax-sheltered accounts like IRAs or 401(k)s, where selling won't trigger taxable capital gains. If your tax-sheltered accounts constitute a large enough share of your overall kitty, you should be able to move the needle by rebalancing there alone. 

If you can't achieve your desired asset allocation by shifting assets within your company retirement plan or IRAs, you'll need to get creative about making adjustments within your taxable accounts while also limiting capital gains. (Note that this is a nonissue for those in the 10% and 15% tax brackets who pay no tax on long-term capital gains.) Rather than selling appreciated winners, for example, you could restore balance by steering new dollars to the unloved positions during several months. You could also stop reinvesting dividend and capital gains distributions in the positions that have grown beyond their desired size, thereby making sure they don't grow any larger. 

Tip 4: Be prepared to tinker.
If your portfolio consists exclusively of index funds or individual stocks and bonds, figuring out how to restore balance may be straightforward. But if you have actively managed funds in your portfolio, and especially those that range across asset classes and the style box, pinpointing where to make changes can require some trial and error. For example, even if you've scaled back your small caps to a shadow of their former selves, you may end up with an outsized small-cap weighting because some of your large- and mid-cap holdings own small caps, too. For my money, entering holdings into the Instant X-Ray tool (even if I have those same holdings saved as a portfolio on Morningstar.com) provides the easiest way to toggle between my holdings list/dollar amounts and X-Ray. That way I can test the impact of various changes.

Tip 5: Get over your trepidation about buying bonds.
Rebalancing is invariably counterintuitive and difficult to do, and that's particularly true today. Stocks aren't cheap, but they're not particularly overvalued, either, based on Morningstar's price/fair value measure. Meanwhile, bonds look less compelling, with yields quite low and the Fed signaling its intentions to end its bond-buying program. Even dedicated strategic asset-allocation enthusiasts might be questioning the wisdom of buying a whole bunch of bonds at this time. 

If you currently have a larger underweighting in bonds and are concerned about putting money to work in an asset class that could sell off, don't second-guess the wisdom of rebalancing altogether. Instead, let your time horizon help guide your positioning. If you're moving money into bonds because you expect to spend it within five years or so, by all means keep it safe by sticking with shorter-duration bonds or even cash [Note, duration is a measure of interest-rate sensitivity]. Another idea is to move that money from stocks and into cash, then institute a rebalancing program for putting that money to work in bonds by investing fixed sums at regular intervals. Such a program will protect you from moving a bunch of money into bonds at what in hindsight was a bad time.

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