Rebalancing Act
Last year's topsy-turvy markets, Barnes says, drove home the benefits of proper asset allocation to at least some investors — "You can tell they've had the 'Aha!' kind of experience." But by and large, he thinks people have learned the wrong lesson: "The unfortunate thing a lot of people learned from the last 10 years and [had] reinforced [Wednesday] is that Greenspan and the Fed will bail you out of your mistakes."
The more useful wisdom to take from the market's recent turmoil is the importance of diversification. The idea that you can protect your investments through diversification is based on the belief that no one investment category (we're talking asset classes, not stocks vs. bonds) will significantly outperform over the long term and that no one can consistently pick which subclass will outperform during a particular period. It's prudent, then, to have exposure to a range of fund types: small cap as well as large, foreign as well as domestic, value as well as growth. (For more on how to create an allocation plan that matches your goals and risk tolerance, check out our SmartMoney One Asset Allocation System.)
Even if you survived year 2000 relatively unscathed, it's important to check whether gains or losses have thrown your allocations out of whack, and if so, to adjust your holdings. To help, we asked financial planners for tips on what to consider when rejiggering your portfolio.
Donald Chou, a certified financial planner with Professional Financial Advisors in San Juan Capistrano, Calif., recommends that, as a first step, you should review any major life changes that occurred in 2000. Both positive and negative changes — retirement, marriage, divorce, raise, pay cut — can alter your financial objectives. "You want to make sure your portfolio is consistent with those goals and objectives and also with your time horizon," Chou says. Barnes adds that while it's good to do an annual financial checkup, ideally you should reallocate whenever your situation changes significantly. If you haven't reallocated in some time, though, act now to make sure your investments are in line with your goals.
Once you've reviewed your short- and long-term goals and done a gut-check of the level of risk you can tolerate, figure out where you stand. It's worthwhile to tally your net worth, which is easy to calculate. Then, when readjusting the percentage of your investments allocated to different categories, consider only long-term assets. In other words, don't count your checking-account balances or the cash stash you maintain for emergencies. If you're just starting out, however, reviewing your net worth isn't especially important, Chou points out.
Investors with balance sheets below $100,000 generally have longer time frames to build up retirement assets and the like, so it's OK to have investments overweighted toward higher-risk areas. Investors with a long time horizon, Chou says, "can afford to be more growth-oriented and undiversified."
Barnes suggests that investors calculate their ideal allocation — "have a map for how they want their portfolio to look ideally" — before even pulling out their financial statements. He believes the plan "should be constructed in a vacuum, without any view as to what you own right now."
Many investors, of course, know only too well what's become of their portfolios in recent months. If you aren't one of them, it's time to figure out exactly what your holdings are worth now. Consider all your investments: IRAs, 401(k) accounts and brokerage accounts, as well as savings earmarked for your children's education.
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Another thing to watch out for is style drift. If your value fund has started acting like your growth fund, or vice versa, you aren't diversified. "If you get new managers or there's a change in the philosophy in how the money's managed, those are very important things to look at," Chou advises.
If you discover that your investments don't line up with your allocation model, you should act now, Barnes says. "Get it done. Dollar-cost averaging is fine for incremental purchases in the portfolio, but reallocation needs to be done immediately." Keep tax efficiency in mind. Dee Lee, a certified financial planner in Harvard, Mass., says that "the best tax-efficient place to [reallocate] is within your deferred compensation plan," such as your 401(k). By adjusting your allocations through redemption and reinvestment within your tax-deferred accounts, rather than taxable accounts, you can avoid triggering capital-gains taxes. Outside of tax-shielded accounts, you can protect yourself by simply directing new investments to underweighted areas. If you have too much invested in an aggressive growth fund, for instance, you can steer new money into a value fund. An alternative is to balance gains with losses and sell a combination.
Once you've realigned your portfolio, resist the temptation to tinker with your allocations based on short-term returns. If an industry fund or an emerging-market fund dips, but still fits your long-term allocation plan, then keep it in your portfolio. Says Lee, "The key is to diversify the portfolio so you're not going to panic in a cyclical year." After all, that's what this exercise is all about.
