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Investing Specialists

Rebalancing Moves You May Need to Make

Investors who haven't checked in for a while may find their U.S. stock allocation is oversized compared with their overseas and bond holdings.

Note: This article is part of Morningstar's January 2015 5-Point Retirement Portfolio Checkup special report.

Your asset allocation (the mix of stocks, bonds, and cash) is the biggest determinant of your portfolio's performance over time. So, during your checkups, you'll want to pay the most attention to it.

Your allocation is one of the first pieces of information you'll get in a brokerage or 401(k) statement, usually in the form of a pie chart. You can also use Morningstar.com's Premium Portfolio X-Ray or Instant X-Ray tool to see your true asset allocation based on the underlying holdings of all your mutual funds.

Depending on time horizon, return needs, ability to weather ups and downs, and a mix of other factors, most investors will set allocation targets, reflecting their desired exposure to each asset class. If you don't have allocation targets, check out my tips for setting them up. Although your allocation targets will gradually change over time as you get older (and closer to your investing goal), your portfolio's actual allocations will fluctuate year-in and year-out depending on market movements. All else equal, assets that have performed well will consume a bigger share of your portfolio's value, and assets that have done poorly will shrink.

You'll want to make adjustments if you see big divergences in your current portfolio allocation versus your allocation targets. If your exposures to any given asset class are more than five or 10 percentage points off of your target allocations, it's probably time to get in there and do some rebalancing, trimming positions that have grown beyond your target and adding to those that have shrunk.

Given Recent Market Performance, How Might My Allocation Have Changed?
Recent volatility aside, we've had a great equity-market runup for five years running now, so investors who haven't been rebalancing along the way may be heavier on stocks than they intended to be. For instance, a portfolio that was 50% stock/50% bond five years ago would now be about two thirds equity.

Digging in a little deeper, you may also find changes in your U.S. and foreign stock allocations. Thanks in part to the U.S. market's strong performance relative to major foreign markets, the U.S. is now more than half of the world's market capitalization. Most U.S. investors don't need 50% foreign-stock exposure, but it's also true that most U.S. investors probably have too much of a home-market bias. International markets have been weak recently; foreign large-blend funds lost about 5% on average in 2014, while U.S. large-blend funds were up 11%. So you may find that your international exposure has fallen below your target range.

If you've also found that you are light on bonds, there are a few things to keep in mind. First, if you're adding bond exposure, it makes sense at this point to focus on plain-vanilla, core funds rather than trying to guess the direction of interest rates. Long-duration bonds had a great rally in 2014, but it's an open question and quite debatable whether they'll repeat that performance in 2015. So, if you're adding fixed-income exposure, keep it core, limit your interest-rate sensitivity to short- or intermediate-term bonds, and also keep credit quality generally high.

At this juncture, I think it makes sense to add to a core, flexible fixed-income fund--perhaps an active funds such as  Metropolitan West Total Return Bond (MWTRX) or maybe  Dodge & Cox Income (DODIX) or you could use an index fund like a total bond market tracker to keep your costs down while giving you fairly well-diversified exposure to the bond market.

If you're getting close to retirement and notice that your stock allocation is dramatically above your target, de-risking your portfolio is particularly important. But you may not want to go straight into bonds from stocks given the current cloudy outlook for fixed income. First, you could move the money that you have earmarked for bonds into cash immediately to de-risk the portfolio. Then you could slowly deploy that money into the bond market over the next year or two. The benefit of dollar-cost averaging is that you will be able to obtain exposure to a variety of interest-rate climates. So, if interest rates climb, you won't have put a lot of money into the market at what, in hindsight, could have been an inopportune time.

What If I Am Underweight on Stocks?
If you've compared your portfolio's asset allocation to your targets and found that, in fact, you're light on stocks, there are a couple of key things to keep in mind. First, even as the market isn't egregiously overvalued currently, it's not especially cheap based on Morningstar analysts' price/fair value estimates for all of the companies in their coverage universe. The typical company we cover is trading just above its analyst's estimate of fair value. That doesn't mean stocks are terribly expensive, but nor are there a lot of bargains to be had.

Given this, investors who are light on equities may want to take a similar dollar-cost averaging approach that I recommend for investors who are light on bonds. Further, you may want to consider value-oriented funds as you bring your allocation in line with your target. In this kind of market environment where stocks aren't particularly cheap, but there may be bargains here and there, it could be good to have an accomplished bargain-hunting manager working on your behalf. Some of our longtime favorite value-oriented funds include  Dodge & Cox Stock (DODGX),  Vanguard Windsor II (VWNFX),  Vanguard Value Index (VIVAX), and  Tweedy, Browne Global Value (TBGVX).

What If My Cash Allocation Is Low?
The target allocation for cash typically depends on your life stage. If you're still working, you want to think about having an emergency fund in place. The standard rule of thumb is to have three to six months' worth of living expenses set aside in true cash instruments, like savings accounts or money markets, for emergencies.

If you're retired, you'll want to set the bar a little higher in terms of liquid reserves. I have written a lot about the bucket strategy for retirement-portfolio planning, where investors keep their nearer-term cash holdings in one bucket and their longer-term bond and stock investments in other buckets. I typically recommend that retirees keep about six months' to two years' worth of living expenses in true cash instruments in bucket one. The idea is that if your bond or your stock portfolio is gyrating around, you know that your liquid reserves will get you through some volatility in those longer-term pieces of your portfolio.

As you are calculating your liquid reserves, be careful not to use Morningstar's X-Ray for this part of the process. X-Ray takes into account the underlying cash exposures in your various mutual funds, which you won't have access to as liquid reserves if you actually need to get the money out. So, hand-calculate your dedicated liquid reserves to get an accurate reflection of how much true cash you have on hand currently.

If you are retired and need to refill your cash reserves--there are a few key ways to go about it. One strategy that I recommend is to see how far your dividend and income distributions go toward refilling bucket one. Think about having your investment income and dividend distributions channeled directly into your cash account, so that account refills automatically on an ongoing basis. If those income and dividend distributions are not sufficient to meet your living expenses or to refill bucket one, you could think about rebalancing to further boost your liquid reserves.

Note: This article was adapted from Christine Benz's 6 Step Portfolio Checkup Web seminar.

See More Articles by Christine Benz

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