Rebalance Your 401(k) With This Annual Checkup

In the first part of this column, I discussed the qualitative rules I use to winnow attractive funds from a client's 401(k) choices. In the second part, I will show you how to apply quantitative techniques to complete the portfolio allocation.

In the previous article, I selected four funds -- (VWELX Quote)Vanguard Wellington, (BRWIX Quote)Brandywine Fund, (SSHFX Quote)Sound Shore Fund and (VFINX Quote)Vanguard 500 Index -- for possible inclusion in my client's 401(k) plan. A simple 25% allocation to each fund, rebalancing annually, would have yielded a 15.3% annualized return from Jan. 1, 1991, through Oct. 4, 2001. Although this was slightly less than what some of the individual funds returned over this same period, it was also significantly less volatile, as I'll show in more detail later.

Annual returns for each fund for the 10 years though 2001's year-to-date returns are shown below.

	VWELX	BRWIX	SSHFX	VFINX
12/31/1991	23.7%	49.2%	32.2%	30.2%
12/31/1992	7.9	15.7	21.2	7.4
12/31/1993	13.5	22.6	12.0	9.9
12/31/1994	-0.5	0.0	0.3	1.2
12/31/1995	32.9	35.8	29.9	37.5
12/31/1996	16.2	24.9	33.3	22.9
12/31/1997	23.2	12.0	36.4	33.2
12/31/1998	12.1	-0.7	4.4	28.6
12/31/1999	4.4	53.5	0.1	21.0
12/31/2000	10.4	7.1	20.2	-9.1
10/4/2001	-1.2	-22.0	-4.1	-18.3
# years	10.75
Cumulative returns	12.8%	16.4%	16.4%	13.9%
Standard deviation	10.6%	22.5%	15.0%	18.2%
Source: Morningstar

Vanguard Wellington shows returns well below the others, but I don't immediately reject this fund because it also has annual variation in returns significantly below the other funds (Vanguard Wellington is a balanced fund with 34% of current investments in bonds, meaning returns are lower but so is volatility).

Gauging Future Returns

What if I allocated 25% of my client's funds to each of these four funds and rebalanced annually -- what would the historic returns and volatility tell me about my client's future returns? While there are professional software products available to simulate returns, for the purposes of illustration, I've put together an Excel Spreadsheet using the annual returns above.

The spreadsheet works as follows: ...