In short, rebalancing means that you regularly reduce your holdings in those investments that have performed best while sending more to your laggards. Although counterintuitive, this practice is straight out of Investing 101--the importance of buying low and selling high.
To ill
ustrate the merits of rebalancing, financial writers often hark back to the second half of the 1990s, when so-called TMT (technology, media, and telecom) shares consumed a disproportionate share of many investors' portfolios. When those racy stocks sank, so did their portfolios. That's not apt to be a risk for most investors right now; many of you learned, the hard way, the risk of loading up on a single risky sector. But the market trends of the past five years have still been quite pronounced, with emerging markets besting developed bourses and smaller stocks beating large. If you haven't actively cut back on your winners recently, it's possible that your portfolio is out of sync with where it needs to be.
Here's how to find out if your portfolio needs a tune-up, as well as the steps you should take to get the job done.
1) Find Out Where You Are Now
If you're tackling any task at the portfolio level, you need to be able to look at all of your accounts--all of your accounts and those of your spouse--as a unified whole. Morningstar's Instant X-Ray helps you do just that.
To use X-Ray, simply enter each of your holdings, along with the amount or the percentage of your portfolio you have in each. Then click "Show Instant X-Ray." You'll not only see your portfolio's breakdown among stocks, bonds, and cash, but you'll also see how it's distributed around the globe and across Morningstar's investment style box. You can also see how much you have in each market sector, and view your largest positions in individual securities.
2) Find Out Where You Need to Be
To determine whether you need to make any changes to your current mix, it's essential that you have an idea of how much you should have in stocks, bonds, and cash given your goals, time horizon, and savings rate. Bear in mind that your optimal stock/bond/cash mix--or asset allocation--will be a moving target, as most of us need to tilt our portfolios toward conservative investments as we get closer to retirement or any other savings goals. If you haven't revisited your own asset allocation in a few years, it's a good idea to do so before you undertake any rebalancing.
A financial adviser can give you guidance on the appropriate asset allocation for you. One very rough rule of thumb is to subtract your age from 110; the remainder is about how much you'll want to invest in stocks. For example, if you're 40, you'll want to keep approximately 70% of your portfolio in equities and the remainder in bonds.
3) Compare Your Target Allocations with Where You Are Now
Now it's time to evaluate if you need to make any changes. Start with your current stock/bond split, according to Instant X-Ray. Is it dramatically out of whack with your targets? Don't get too concerned about minor divergences--if your stock weighting is, say, 2 percentage points less than your optimal allocation, you probably don't need to make any changes at all. (Remember: The most successful investors are usually those who trade the least; trading frequently may also trigger unnecessary tax and transaction costs.) But if your current allocations differ from your target allocations by 5 percentage points or more, that's something you'll want to address.
4) Be on the Lookout for Sector, Investment-Style and Geographic Bets
Next, you'll want to size up whether your portfolio's fortunes are riding on certain parts of the market. Using Instant X-Ray again, check out your portfolio's sector positioning relative to a broad global market index. (The iShares MSCI World ETF is a good proxy, though be aware that the index it tracks doesn't include any emerging markets shares.) Are you heavy on financial stocks? Health care? Again, you're looking for big inadvertent bets here. If your portfolio is heavily tilted toward a given sector and you're comfortable with that positioning, fine. Just know what types of bets you're making.
While you're at it, check out your portfolio's positioning in Morningstar's style box. Although smaller stocks have recently ceded ground to large, you may still find your portfolio skewed toward smaller stocks because they've prevailed for most of this decade. As a reference point, the MSCI All Country World Index (which is a market-cap-weighted benchmark that does include emerging markets), currently has approximately 85% of its assets in large-company stocks, another 13% or so in midsize companies, and the remainder in small-cap stocks. Your portfolio needn't be a mirror image of that index, mind you, but you do want to be sure that you're not inadvertently wagering on a continued rally in smaller shares.
Finally, check up on your portfolio's geographic exposure. With the run-up in emerging markets, there's a good chance that your portfolio currently has a lot riding on such markets. That may be intentional, but recognise that such markets are prone to substantially greater performance swings than are developed. Check your portfolio's allocation to stocks domiciled in the following regions: Emerging Europe, Middle East/Africa, Central & Latin America, Emerging 4 Tigers, and Emerging Asia ex 4 Tigers. These markets account for approximately 15% of the MSCI All Country World Index, so if your exposure to them is substantially higher than that figure, it may be time to take some of your winnings off the table.
5) Tinker, Starting with Your Tax-Sheltered Accounts
If your portfolio is in line with your target asset allocation and you're not making any inadvertent sector, style, or geographic bets, your work is done. But if you determine you need to make some changes, you'll want to go back to your portfolio and do some tinkering.
In some cases, the alterations you need to make might be obvious--if you're uncomfortably heavy on emerging markets, for example, trimming any emerging markets-specific investments should resolve the problem. Getting to the bottom of other bets might take a little more digging into the individual funds' underlying portfolios. You can see the asset allocation for each of your holdings, as well as the sector, style, and geographic breakdowns, by clicking on the "Portfolio" tab in the left-hand navigation bar for each individual fund's report. 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.
6) Plan to Make a Habit of It
Conventional wisdom holds that there are two ways to rebalance--either you can rebalance on a set schedule, say, during ISA season, or you can rebalance whenever your portfolio gets dramatically out of whack with your targets.
Our advice is to split the difference. While 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. (As we've already noted, trading too often triggers unnecessary tax and transaction costs, and you also risk falling into a short-term mindset.) Schedule a top-to-bottom portfolio review at a fixed time each year. But rebalance only when your portfolio's allocations have gotten dramatically out of whack with your targets.
