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Here's How to Play the Portfolio Rebalancing Act

David Edwards

02/20/02 - 01:28 PM EST

At the start of every calendar year, I rebalance my clients' accounts to certain target sector weightings. For example, I started 2002 with about 30% in health care and 20% in technology stocks, but my target for these sectors is 25%. In January 2000 I had 40% in technology and 15% in health care.

It's easy to gravitate toward better-performing sectors, so committing to an annual rebalancing process means taking money out of stocks that are performing well and putting the proceeds into stocks that are doing poorly. I sell high and buy low (as opposed to buying high in the hopes of selling higher).

Rebalancing, however, usually generates capital gains. Because I rebalance in January and February, I have the rest of the year to look for offsetting capital losses. For example, not every stock that I buy in January will be showing a gain by the fourth quarter. A short-term loss taken in the fourth quarter can be set against a long-term gain from the first quarter.

Two years ago I wrote a column on how to compute your annual return and estimate the risks in your portfolio using an Excel spreadsheet and a variety of data sources. Doing a good job would take about six hours for a 40-stock portfolio. Thankfully, Web tools can now compress this job down to about an hour.

The most accessible tool for individual investors is the Morningstar Portfolio X-Ray tool, available in a limited version for free and in an extended version as part of the Premium Membership package for $11.95/month after a 30-day free trial (no, I'm not getting a referral fee from Morningstar).

Analyze the following hypothetical portfolio using the free tool:

Check the Balance
This portfolio may have hidden risks and overlapping stocks
Symbol Description Holding Value
ADVP Advance PCS $12,000
DELL Dell Computer 6,000
EMR Emerson Electric 5,000
GE General Electric 10,000
JAMRX Janus Mercury Fund 5,000
NOK Nokia ADRs 5,000
WESWX Westwood Equity Retail Fund 7,000

Fill in the above values and click "show instant X-Ray." (Note: the premium version lets you enter share quantities, cost basis, etc., and lets you save the portfolio for future review.) Taking into account both stocks and mutual funds, Morningstar's Overview report gives you your asset allocation (percentage of stocks, bonds and cash); breakdown of stocks (small-, mid- and large-cap, growth vs. value, sector allocations vs. the S&P 500); stock types (cyclical, growth, aggressive growth, etc.); average price-to-earnings pricetoearnings, price-to-book pricetobook and yield, and values relative to the S&P 500; and the top 10 holdings in your portfolio.

If you click on the "diagnostics" tab, Morningstar provides an analysis of the risk factors in your portfolio.

The premium version of Morningstar's X-Ray gives you additional detail. For example, the Stock Intersection report shows overlaps between your stocks and mutual funds, and computes your overall exposure. In the hypothetical portfolio, Nokia (NOK - Cramer's Take - Stockpickr) is the largest holding of the Janus Mercury fund, while Citigroup (C - Cramer's Take - Stockpickr) and AOL Time Warner (AOL - Cramer's Take - Stockpickr) appear in both Janus Mercury (the aggressive growth fund) and Westwood Equity (the value fund). Even if you invest only in mutual funds, you may find that you're less diversified than you thought, because of stock overlap among the funds.

Another convenient report is a quick estimate of your portfolio performance over the last quarter, year and three years (assuming that your positions remained constant) in absolute terms and relative to the S&P 500. Morningstar will compute the actual performance if you've entered all your buys, sells and cash activity through the performance period.

I suggest the following action plan:

  • Analyze your current assets. I recommend including all your accounts: taxable, IRA and 401(k).

  • Determine the risk factors.

  • Decide your risk parameters (e.g., no more than 30% tech, no more than 5% in any one stock, no less than 30 stocks in the portfolio).

  • Determine the sell list (for example, sell 6% of Nokia in the hypothetical portfolio to reduce the exposure to under 5%).

  • Compute the capital gains taxes on the sell list (they are large, perhaps there are some stocks showing a loss that should be sold).

  • Determine the buy list (the hypothetical portfolio is 5% in financial services vs. a 15% weighting in the S&P 500).

  • Check back in September on year-to-date capital gains. If they are still positive, take losses now to avoid the year-end rush.