Portfolio rebalancing made easy

Your step-by-step guide to restoring your asset allocation

Christine Benz 10 November, 2009 | 1:32PM
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If you've put off rebalancing because the process seems daunting to you, read on. The following step-by-step guide simplifies the process using tools on Morningstar.co.uk.

Step 1: Determine your asset-allocation targets
Your first step in the rebalancing process is to make sure you have an asset-allocation framework. If you had a stock/bond target that made sense for you before the recent market downturn, it should still fit now. And if you don't have an asset-allocation plan, it's time to make sure you have one. My favourite "quick and dirty" method of getting in the right asset-allocation ballpark is to look at the asset allocations of target-date funds geared toward individuals in your age range (you can search for target date funds in our Fund Quickrank). Of course, there are no one-size-fits-all asset-allocation solutions--none of us knows how long we'll live, for one thing--and these funds can vary widely in their asset allocations and in their overall quality, but they can also be a good starting point for your asset-allocation framework.

The Web is also full of tools and questionnaires to help you with asset allocation. If you have a portfolio in Morningstar.co.uk's Portfolio Manager (more on this in Step 2), the tool helps you find the best combination of holdings to meet your goals.

Step 2: Find your current asset allocation
After you've determined what your optimal asset allocation should be, it's time to take a look at where you are now. If you're like many people, you may have been moving your investment statements directly from the doormat to your desk drawer, afraid to glimpse at how much money you've lost. But it's time to pull all of those statements out and take a look, or go online for an even more current view of your portfolio. Focus not so much on your recent losses, but instead take note of your current asset allocation.

Keeping track of your portfolio's asset allocation by hand can be a bit cumbersome and inexact, particularly because most funds aren't pure stock or bond. It's not uncommon for stock funds to hold double-digit cash stakes, for example. For the clearest possible read on your asset allocation, I recommend Morningstar.co.uk's Instant X-Ray tool, which drills into each of your fund holdings to determine how they're allocated by asset class and investment style. If you store a Transaction portfolio on Morningstar.co.uk, simply click on the X-Ray tab view within Portfolio Manager to see your current split among cash, UK and foreign stocks, bonds, and other. The X-Ray tab also depicts how your holdings are dispersed across the Morningstar Style Box.

If you haven't yet stored your portfolio on Morningstar.co.uk, click on the free Instant X-Ray tool, found on the Tools cover page. Once in Instant X-Ray, enter the ticker for each of your holdings as well as the sterling amount you hold in each. Then click Show X-Ray for your asset allocation. Take note of your current asset allocation and compare that with your asset-allocation targets in Step 1. Determine where you need to add and subtract to restore your portfolio to your target levels.

Step 3: Formulate a rebalancing plan
If your portfolio is in line with your target asset allocation and you're not making any inadvertent style or sector bets, your work is done.

Most likely, however, your analysis of your current asset allocation versus your targets indicates that your portfolio is light on stocks.

When it comes to deciding which securities to add, as well as how much to add to each, you'll probably find that the process of overhauling your portfolio is a matter of trial and error. Here again, I'd recommend Morningstar's Instant X-Ray tool to help you evaluate the impact of various holdings on your asset-allocation mix before you decide to buy. Also, pay attention to the impact that various holdings have on your style-box positioning and sector weightings. Your stock portfolio doesn't need to be an exact clone of the broad market, but you should at least be aware of whether your portfolio is skewing heavily to one style or sector.

In some cases, the alterations you need to make are obvious--if you're heavy on bonds, for example, adding to stocks should resolve the problem. Getting to the bottom of other bets might take a little more research. 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.

It also pays to consider tax consequences when rebalancing. Conventional wisdom holds that you should concentrate your rebalancing efforts in your tax-sheltered accounts, because you won't have to pay capital gains tax if you determine you need to sell shares. That advice may be less relevant this year, given that many of your taxable holdings are well in the red and you won't face tax consequences if you need to unload something. Alternatively, you could try to correct your portfolio's imbalances not by selling but by directing a bigger share of future contributions to those holdings that need beefing up. In so doing, you'll save on tax and transaction costs.

Step 4: Plan to make a habit of it
There are two ways to rebalance--either you can rebalance on a set schedule, say, every December, or you can rebalance whenever your portfolio gets dramatically out of whack with your targets. My advice is to split the difference. While I think 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. Schedule a top-to-bottom portfolio review at a fixed time each year, but rebalance only if your portfolio's allocations have gotten dramatically out of whack with your targets.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances, due out in January 2010.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Christine Benz

Christine Benz  is director of personal finance at Morningstar and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.

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