Get Your 'Rebalancing Act' Together

Maybe I miss the clean notebooks and sharpened pencils of a new school year, but I've always thought of the beginning of autumn as a good time to peek inside my portfolio and get things in order. Has my asset allocation shifted significantly over the last six months? Do I need to make some changes?

Granted, this rebalancing chore, which financial planners insist we must do every six months, is not exactly a task to relish, even in the best of bull markets when you've got a lot of double-digit plus signs to peruse.

But after the summer we've endured, there is especially good reason to see if the market mayhem has thrown our allocations way out of whack. Time for a look at the big picture.

The idea behind this exercise is simple. Diversification -- that is, spreading dollars among funds that invest in different kinds of assets -- can reduce overall risk or volatility in a portfolio while enhancing returns. This method also can keep us from using our rearview mirror to chase recent hot performers. As we are learning the hard way, avoiding assets that may be temporarily out of favor and going with ones that have done well recently often leaves us stuck with yesterday's news.

That said, anyone who has read my columns knows I don't bow to the altar of diversification. But you just can't ignore the fact that regular rebalancing is an important part of putting together a portfolio.

Here are some things to keep in mind as you do so:

Keep It Simple

It all basically comes down to stocks, bonds and cash. Or better yet, aggressive vs. conservative plays.

Mutual fund marketers have had a field day slicing the asset allocation pie into ever smaller pieces. With category classes multiplying and subsector funds a growing rage, you can go crazy trying to fill the "micro-cap international hybrid" slot in your portfolio.

It doesn't have to be that hard. When rebalancing, the point is really to get a sense of the basics. Traditionally, the division has been, "How much is in stocks?" and "What percentage in bonds?" Just start by asking yourself those questions. (And don't forget, you should have a cushion of cash or money market funds -- three to six months of expenses -- in the event you lose your job or get hit with an unexpected big bill.)

But because bonds and stocks are becoming more correlated, and because many times certain bonds can be more aggressive investments than some stocks, I prefer to draw the distinction in another way. What percentage is conservative? What percentage aggressive?

Ask yourself, "Roughly how much do I have in stocks or the more aggressive side of the equation?" You just want to know if your basic mix of assets is going to get you where you want to go.

Review Your Goals -- but Forget the Rigid Formulas

To do that, of course, you need to know your investment goals, risk tolerance and time horizon.

There are a lot of stupid rules of thumb that supposedly will tell you how much you need in stocks without considering those individual circumstances. Many a planner will suggest you can subtract your age from 100 to find the portion you should have in stocks. But a 60-year-old with a long life expectancy and some longer-term goals can, of course, have a lot more than 40% in equities.

To review how your allocation fits with your investment personality and objectives, check out Jim Cramer's Asset Allocation Adventure.

Think Taxes

Does your current mix of investments no longer match your needs? Has the rough ride on Wall Street reduced your stock allocation to 65% from the 80% you originally wanted? (You may be surprised if you haven't completed your rebalancing chores for a while -- your stock portion may be bigger than you thought, given the huge equities run-up we've seen prior to the summer.)

If you are overstocked on stocks and want to get back to the levels you set for yourself, you have to remember taxes. If you can, work within a tax-deferred account such as an IRA or 401(k) to make the switches so you don't get walloped by a capital gains tax hit. But if you have to work in your taxable account, this isn't a bad time of year to do so -- right before many funds make year-end distributions.

If you just don't want to consider taxes in the equation, instead add fresh investment money to the part of your portfolio that is wanting.

Overlap Alert

The part of rebalancing many of us ignore is whether our funds are buying similar kinds of holdings. That's just the opposite of diversification -- and the result can be that your returns end up going nowhere. How to make sure your funds don't overlap? You can look into each fund's portfolio and compare the holdings, but that can be a time-consuming job. Or you can compare your funds' R-squared ratings, which measure correlation to an index. Check out my column, How Many Funds Should You Own?, for more on this.

Don't Get Carried Away

Remember: big picture. If you're a few percentage points off your broad allocations, it doesn't make much sense to worry about rebalancing this time. Wait until the end of the year. You'll be more likely to tackle this task on a regular basis if it doesn't eat up whole weekends of your time.

The results of your maintenance may be a bit scary -- if stocks are down, you can put more money into them and think about trying parts of the market that aren't so hot. Yes, this forces you to sell high and buy low. But you're not engaging in market timing here. The "rebalancing act" is just a smart way of tuning up your portfolio on a regular basis.