For Best Rebalancing Results, Get Out Your Scalpel

Rebalancing--the counterintuitive practice of scaling back your portfolio's winners and adding to its losers--is an important aspect of portfolio hygiene. The process won't necessarily enhance your portfolio's return, but over time it will tend to reduce its volatility level.

You often hear rebalancing discussed around year-end, as some investors sensibly tie in rebalancing with their year-end tax-related maneuvers. Retirees might unload highly appreciated winners to meet their required minimum distributions from their tax-deferred accounts, for example. Other investors might find tax losses to help offset winning positions that they’re selling from their taxable portfolios. 

But if you didn't squeak in rebalancing before year-end, it's not too late: It's still safe to say that portfolios that haven't been rebalanced in a few years are tilting heavily toward stocks. A portfolio that was 50% total stock market/50% total bond market three years ago would now be 57% equity/43% bond if it had never been touched, and 70% equity/30% bond if it hadn't been rebalanced during the past five years. 

What's Simple in Theory…
But while rebalancing is simple in theory, in practice it can be tricky to determine exactly what moves to make to restore balance.

For investors who split their portfolios among two broad-market index funds, as in the examples above, restoring the portfolio's balance is straightforward: Cut the stake in the equity-index fund, add it to the bond fund. Done. The same is true if an investor holds individual stocks or sector- and style-specific funds: A glance at the portfolio's weightings may make it obvious which holdings to add to and which ones to trim.

But for most portfolios, the logistics of rebalancing are more complicated. You could use the blunt-instrument approach and scale back all of your equity holdings by an equal percentage amount; if your portfolio's equity allocation was 20% above your target, you could reduce each of your equity funds and individual stocks by 20%, too.

But there are a couple of problems with this tack. First and most important, not all of your investments have contributed equally to the equity stake's appreciation. Moreover, the managers of your most highly appreciated holdings may have already taken steps to trim the most overvalued parts of their portfolios and have redeployed the money into holdings they currently consider to be better buys. And even equity funds may not be all-equity at this point, so trimming such holdings may not reduce your equity exposure as much as you had hoped. Some value-minded funds have been stockpiling cash. For example,  Sequoia (SEQUX) currently has about 17% of its portfolio in cash, while  Yacktman (YACKX) has 21% of its money on ice. In a way, some of those managers have beaten you to the punch in trying to make sure you don't get burned in an overheating market; if you have value-oriented, defensive managers working for you, you probably have less reason to rebalance than other investors do. 

Let X-Ray Lead the Way
Instead, a better way to determine which of your equity holdings to trim and which to add to is to let Morningstar's X-Ray functionality guide the way. If you've determined that it's time to rebalance because your portfolios' exposures to the major asset classes (domestic equities, international equities, bonds, and cash) are 5-10 percentage points higher or lower than your targets, start by using the X-Ray Overview layer to see where your portfolio is at odds with the broad market. Ideally, you should focus your rebalancing efforts on the tax-sheltered portion of your portfolios--your IRA and company-retirement plan--because you won't pay taxes if you need to sell an appreciated winner. 

In the X-Ray Overview layer, you can see how your sector exposures stack up to the S&P 500's. To help judge your Morningstar Style Box exposures, total market indexes currently have about 24% in each of the large-cap squares of the style box, 6% in each of the mid-cap squares, and 3% in each of the small-cap squares. Of course, you may be intentionally overweighting and underweighting a specific style or sector--as discussed here--but it's still important to be aware of whatever bets you're making. Morningstar's price/fair value ratios for each of the market sectors can help you determine how concerned you should be if a given market sector takes up an outsized position in your portfolio. (Health-care and technology stocks are currently among the most overvalued pockets of the market, according to Morningstar equity analysts.) 

But even as the X-Ray Overview shows you where you have unwanted imbalances, it can be difficult to know how to correct them, especially if you hold actively managed funds that employ free-ranging strategies. If you're heavy on a given asset class--say, small- and mid-cap growth stocks, or technology and biotech names--you'll have to figure out which of your holdings is contributing to the outsized exposure. 

That may be obvious if you know your holdings extremely well, but if it's not, click on the X-Ray Details tab. There you can see the individual constituents in your portfolio through various lenses--asset class, investment style, and sector, among others. Thus, you can see at a glance which of your holdings is contributing to your portfolio's overweightings. If one of your holdings is a large position for you to begin with and it's heavily tilted toward a sector that you'd like to reduce, it's an obvious candidate for reduction. 

For example, let's say you were concerned that your portfolio holds too much in the health-care sector, which Morningstar's equity analysts have long liked but believe is expensive now. Not only are individual stocks such as  Biogen Idec (BIIB)--which currently has a Morningstar Rating for stocks of 1 star--probably due for a trim, but so might health-care-heavy fund holdings such as  Vanguard Primecap Core (VPCCX) and  Primecap Odyssey Aggressive Growth (POAGX), each of which has more than 30% of its assets in the health-care sector.

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