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Rebalance Your 401(k) With This Annual Checkup

Once you've decided which funds to include, figure out the ideal allocation using this spreadsheet.

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) Vanguard Wellington, (BRWIX) Brandywine Fund, (SSHFX) Sound Shore Fund and (VFINX) 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.

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:

A $10,000 starting amount was divided to give 25% to each of the four funds as of Jan. 1, 1991.

The portfolio was valued on Dec. 31 of each of the following 10 years, with the net value rebalanced to 25% among the four funds each year.

I included year-to-date returns through Oct. 4, 2001, even though including this partial year muddies the numbers somewhat, because it is very important to see how funds and strategies perform during a bear market.

Relative numbers are more important than absolute numbers. For example, it's more significant to know that fund A has a higher standard deviation on its returns than fund B than it is to know that fund A's standard deviation is 15.0%.

In the table below, I've summarized the cumulative annual return and the standard deviation, which measures volatility, of those annual returns, for the rebalanced portfolio and for several other possible allocations. As you can see, the cumulative return of the portfolio was 15.3%, 1.1 percentage points less per year than either Brandywine or Sound Shore individually, but with less volatility than any of the pure stock funds.

Of these alternatives, a 50% allocation to Brandywine and Sound Shore gives the highest cumulative return with an acceptable amount of volatility. Is it reasonable to assume that a 401(k) allocated accordingly would generate future returns of 16.8%? Unfortunately, no, because the decade ending December 2000 generated unusually high returns not likely to be repeated. However, assuming no substantial changes in the funds' management, it is reasonable (although not guaranteed) to expect that the Brandywine and Sound Shore funds would generate higher cumulative returns than the Vanguard 500 Index fund over time.

It may be a bit complicated, but you can adapt this spreadsheet to perform an analysis of the funds available to you. You'll need 10 years of annual returns, which can be obtained from the Thompson Reports tab on


FundQuote tool, or at

Yahoo! Finance (enter the fund symbol, then select profile and then select performance). The values input by hand are in blue; the self-calculating cells are in black, including the standard deviation figures. If you have fewer than four funds, allocate 0% to the fund columns you don't use. If you are evaluating more than four funds, you'll have to copy and paste cells N3 to N14 to additional columns. You'll also need to modify the formulas in cells C2 and B4 through B14 to reflect the additional funds.

A Final Check

Finally, it's important to make sure you're getting the diversification you need. Funds are classified in terms of mid-cap growth or large-cap value, but the actual securities held may vary from these categories. Morningstar provides a tool called

Instant X-Ray that will help you evaluate an entire portfolio of funds by market cap, style and sector allocation.

As an example, let's look at our 50% allocation to both the Brandywine and Sound Shore funds, which gave the highest cumulative return in our earlier analysis. Using the Instant X-Ray tool and electing to enter the holding information in Percentage Value rather than Dollar Value, I can see how well-diversified this allocation would be.

Under Style Box Diversification, I can see that about 45% of the combined portfolio would be allocated to large-cap companies and 45% to mid-caps. About 40% of the companies are considered value, 40% growth and 20% blend.

Under Stock Sector, I see that most sector allocations are in line with the

S&P 500

, although I see that health care is overweight and technology is underweight. Under Stock Type, I see most companies categorized as Classic and Slow Growth, while very few are categorized as Aggressive or Speculative Growth. The weighted average

price-to-earnings and

price-to-book of the combined funds are lower than the S&P 500 as a whole.

My conclusion? If I recommend 50% each of these two funds, I have a reasonable chance of obtaining good returns in the future. More importantly, I'm not taking on excess risk to obtain those returns.

David Edwards is a portfolio manager and president of

Heron Capital Management, a New York investment management firm. At the time of publication, his firm held positions on behalf of clients in Vanguard Index 500, Sound Shore and Brandywine funds, though positions may change at any time. Edwards appreciates your feedback at