5 Steps to a Refreshed, Rebalanced Portfolio

82% stock/18% bond.

That's the current asset allocation of a portfolio that was 60% stock/40% bond a decade ago and hasn’t been touched since. For investors who haven’t been actively trimming their portfolios’ stock positions, it’s a good bet that their portfolios are courting more equity risk than they intended them to. And if they’ve been actively adding to stocks amid the runup, their portfolios might be listing still more heavily toward stocks.

I’ve been beating the drum for at least a few years about how people getting close to retirement and retirees, especially, should consider rebalancing out of equities. While there hasn’t been a payoff for taking action on that front (except briefly early in 2018 and again later in the year), paring back equities in favor of bonds can help reduce a portfolio’s volatility.

That's rebalancing classic: trimming equities and redeploying the assets into bonds in order to reduce the portfolio’s volatility level. But there are other types of rebalancing besides scaling back stocks in favor of bonds and other reasons to rebalance beyond volatility reduction. Retirees, for example, might trim stocks and move the proceeds into cash to meet living expenses rather than back into the portfolio; that achieves both volatility reduction and cash flow production. Younger investors may also derive a risk/return benefit from adjusting their portfolios’ intra-asset-class exposures. Doing so can add a slightly contrarian, tactical tilt to the portfolio. Right now, for example, long-term-minded investors might derive a benefit from reducing U.S. equity exposure in favor of foreign stocks or scaling back growth in lieu of value.

Yet even though rebalancing can deliver multiple benefits, investors often put it off. There's inertia, of course, exacerbated in this case by human beings' natural aversion to messing with a good thing. Additionally, investors may struggle with how to rebalance. They might not have targets to rebalance back to, or they might assume that rebalancing will trigger a tax bill.

If you’ve been meaning to rebalance but haven’t been sure where to start, the following steps can help you do so quickly and painlessly.

Step 1: Determine what you're trying to accomplish. As discussed above, different investors have different motivations for rebalancing. Knowing what you'd like to achieve can help you identify what type of rebalancing to engage in.

The goal: Volatility and/or risk reduction Rebalancing prescription: Asset-class rebalancing If reducing risk in your portfolio is top of mind--you're concerned about market valuations, you know you get jittery during falling markets, and/or you're getting ready to retire--traditional rebalancing among asset classes, such as reducing stocks in favor of bonds, is the right strategy for you. This type of rebalancing tends to reduce risk but won't necessarily enhance returns. There's a simple reason for that: The periods in which stocks outperform bonds (risk-reduction opportunities) outnumber periods in which bonds outperform stocks (returns enhancement opportunities). In light of the fact that risk reduction is the main benefit of this type of rebalancing, you shouldn't make too big a deal of this type of rebalancing if you know yourself to be unfazed by big market drops. Rebalancing isn't essential if you found yourself bellying up to buying opportunities rather than fleeing the falling market during the financial crisis or periodic market blips.

Life stage is important here, though. Even if you're a notably calm and collected 62-year-old equity investor, if you're closing in on retirement, rebalancing is probably a good idea. That's because new retirees with big equity weightings are particularly vulnerable to bad returns at the outset of their retirements: If they're actively spending from their equity portfolios as they're declining, that has a demonstrated negative effect on the portfolio's sustainability. Use your anticipated portfolio spending to help determine the appropriate allocations you should have to stocks, bonds, and cash, as discussed here. If you don't have enough of the safe stuff, trimming stocks and moving the money into bonds and cash is a smart strategy.

The goal: Return enhancement Rebalancing prescription: Intra-asset-class rebalancing As discussed above, rebalancing within asset classes may help increase a portfolio's return potential. The basic idea is that investment styles zip in and out of favor; periodically pulling back on those that have performed well and sending money to those asset types that have underperformed can build a contrarian element into a portfolio and potentially enhance returns. At the moment, for example, small-value stocks have earned less than half the return of mid- and large-cap growth stocks over the past five years. That trend may not reverse itself overnight, but market history suggests that the return gap won't persist indefinitely.

Investors can also consider rebalancing among geographies. While foreign stocks have performed well recently, in years past they've been clobbered by U.S. names: Over the past five years, total U.S. stock market indexes have trebled the returns of non-U.S. indexes. That sort of persistent underperformance can provide smart rebalancing opportunities. Investors can further fine-tune their rebalancing efforts by rebalancing between developed- and developing-markets stocks.

The goal: Cash flow production Rebalancing prescription: Asset-class and intra-asset-class rebalancing Rebalancing can serve another valuable role for retirees: In addition to reducing portfolio volatility, it can help them find cash for living expenses. With yields still low across asset classes, many retirees have scrambled with traditional income-centric strategies. Today, retirees in search of income can find cash hiding in plain sight in the form of appreciated equity holdings. They can source their cash flows and/or fulfill required minimum distributions by focusing on their most highly appreciated equity holdings--probably those in the growth column of the Morningstar Style Box.

Step 2: Find your current asset-allocation and sub-asset-class exposures. Once you've determined your rebalancing goal and what type of rebalancing you plan to engage in, take a look at your current portfolio allocations. Morningstar's Instant X-Ray tool helps you size up your portfolio's actual exposures based on your portfolio holdings. Instant X-Ray doesn't simply take a large-blend fund and slot it in the large-blend square of the style box; rather, the tool looks at each holding's actual composition and slots it in the asset-class pie and investment-style box accordingly. Thus, X-Ray can give you a clear view of what's actually in your portfolio: its aggregate asset allocation, sector exposure, and style-box positioning.

Step 3: Compare your allocations to your benchmarks. Armed with your portfolio's true exposures, you can then compare them with your targets. All investors should be operating with some type of blueprint for their portfolios' asset-class exposures, as that decision will be the main determinant of the portfolio's return and risk level. A financial advisor can help you customize your asset mix based on your own situation, or you can look to age-appropriate target-date funds and/or Morningstar's Lifetime Allocation Indexes for guidance.

If you're engaging in rebalancing within asset classes, you'll need some benchmarks, too. A total market index can help you gauge style exposures: Today, most such indexes hold roughly 25% in each of the large-cap squares of the Morningstar Style Box, 6% in each of the mid-cap squares, and 2% apiece in the small-growth, -blend, and -value boxes.

If you're managing your portfolio's geographic exposures, the U.S. currently constitutes about 55% of the globe's total stock market value. Meanwhile, roughly 10% of the globe's market cap is designated emerging and the remainder developed.

Step 4: Focus on tax-sheltered accounts. Selling appreciated securities can lead to tax consequences if you're doing so within a taxable (that is, nonretirement) account. That's why it makes sense to concentrate any rebalancing efforts within your tax-sheltered accounts, where you won't face tax consequences for switching things up. While you don't want to get in the habit of overtrading in your 401(k) or other company retirement plans, where you can dodge both tax and transaction costs when you make trades in such accounts, you may also be able to do so within your IRA.

If your taxable account looks particularly problematic--for example, it has way too much equity risk and you plan to retire soon--mind the tax costs before scaling back highly appreciated positions. Investors in the 10% or 15% tax bracket currently pay a 0% capital gains rate, but everyone else is on the hook for capital gains tax. In lieu of triggering a tax bill, see if you can't address your asset-allocation issue by steering future contributions into the underweighted areas of your taxable account. Alternatively, use the specific share identification method when harvesting winners, earmarking high-cost-basis lots for sale rather than lower-cost-basis ones.

Step 5: Identify specific candidates for pruning and additions. Finally, identify specific holdings for pruning and addition. Even if your main rebalancing goal is to reduce risk by scaling back your equity exposure, you can also be savvy about which stock holdings you scale back on and which you add to. As noted above, growth stocks have enjoyed a strong runup so far in 2019--and indeed over the past five years--and therefore may be particularly ripe for pruning. Meanwhile, the tamest bonds (short-term and high-quality) have generally performed the worst.

You can also use rebalancing to address trouble spots in your portfolio--for example, trimming the stock that represents an overly concentrated position or selling the equity fund that has seen a succession of portfolio managers in recent years. In so doing, you can reduce risk and improve your portfolio's fundamentals at the same time.