Portfolio Check-up: Rebalancing Made Simple

A step-by-step guide to restoring your asset allocation on a regular basis

Christine Benz 5 January, 2015 | 12:00AM
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This article is part of Morningstar’s Guide to Investing Ideas for 2015, our comprehensive round-up of where the most promising stocks, funds and markets can be found this year.

If you've put off rebalancing because the process seems daunting to you, read on. The following step-by-step guide simplifies the task using some tools on Morningstar.co.uk.

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 mutual funds geared toward individuals in your age range. Of course, there are no one-size-fits-all asset-allocation solutions--none of us knows how long we'll live, for one thing, but these can be a good starting point for your asset-allocation framework.

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. Gather up your recent investment statements or go online for an even more current view of your portfolio, then 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 investments. 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 our 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 portfolio on Morningstar.co.uk, simply click on the X-Ray tab view within Portfolio Manager to see your current split among cash, stocks, bonds, and other.

After completing the X-Ray, 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.

3. Identify Candidates for Tax-Loss Selling

Before you begin altering your portfolio to put your asset allocation back in line with your targets, you also want to scout around for tax-loss candidates that you hold in your taxable accounts. If you're like most people, you won't have to look too hard to identify securities that are now priced more cheaply than what you paid for them. (This HM Revenue & Customs webpage will help you figure out how to calculate capital gains and losses on shares.)

4. 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 changes are in order. If you're in the market for high-quality funds to consider for your portfolio, check out our Fund Screener, Investment Trust Screener and ETF Screener. If you prefer to pick your own stocks, our Equity Quickrank will come in handy.

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 X-Ray tool to help you evaluate the impact of various holdings on your asset-allocation mix before you decide to buy. 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 equity-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 equity 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 such as ISAs, because you won't have to pay capital gains tax if you determine you need to sell shares. 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.

5. 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 got dramatically out of whack with your targets.

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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