MBN Group Writing Project: Yearend Money Moves – Time to Rebalance Your Portfolio

This entry is my contribution to the MoneyBlogNetwork group writing project. This project is focused on year-end money moves.

It’s time to start saying goodbye to 2007 and get ready for 2008. The yearend is a great time to make adjustements to your portfolio. We call those adjustments “rebalancing.” The easiest way to understand the rebalancing process is with an example.

Let’s say you had the following portfolio at the beginning of the year:

Your allocation calls for you to hold equal allocations of each of the ten sectors of the Dow Jones Total Market Index. So, each sector would represent 10% of the total value of the portfolio.

On December 16, 2007, the portfolio looked like this:

As you can tell, some of the sectors are worth considerably more now than they were at the beginning of the year, while other sectors are worth a lot less. In order to keep our allocation the same, we need to rebalance by selling off some of the sectors that performed well and buying more of the sectors that did poorly. Now, this might run counter to your emotions, but selling “good” investments and buying “poor” investments is exactly what you need to do in order to keep your emotions in check.

How you go about rebalancing depends on following:

1. Commissions charged on the account. Do you have to pay commissions based on the transaction? If so, you might want to limit the number of trades you do since transaction charges can really eat into your returns. On the other hand, if your account is charged a fixed amount each year, such as FOLIOfn, you can most likely reallocate without incurring extra fees.

2. Whether it’s a taxable or non-taxable account. Since transactions will result in capital gains, it might be to your advantage not to rebalance if your current allocation isn’t much different from your target allocation. A general rule of thumb is to reallocate when one asset class or sector is 5% higher or lower than the orginal allocation. If your acount is held in an IRA, then taxes aren’t a concern.

The first step in reallocating a portfolio is to calculate how much over or under the current allocation is from the target allocation:

If your account is held at FOLIOfn, you can rebalance your portfolio with the click of a button. If not, you’ll have to do a little more work by selling off some of the overallocated funds and buying more of the underallocated funds in order to bring you back to your original allocation.

Here’s an example of what your portfolio might look like after reallocation:

If you’ll notice, I didn’t bring this portfolio back exactly to its original allocation. I left IYK alone since it was only $200 off from its original allocation. If you had to pay commissions on each trade, you might decide to even less reallocating than I did by only reallocating the top two and the bottom two.

I can’t emphasize enough how important reallocation is. Sectors and asset classes fall in out of favor all the time. By selling off those sectors that outperform and buying more of the sectors that underperform, you essentially “lock in” your gains. Yes, there’s always the chance that the poor sectors will continue to perform poorly, but there’s also the chance that the better-performing sectors will underperform. As the chart below shows, it’s incredibly difficult to know which sectors are going to perform the best from year-to-year:

Dow Jones Total Market Index Sector Total Returns 1992 - 2006
Click to view in a larger format

Hopefully, I given you the basics on rebalancing your portfolio. I welcome any questions or comments you might have.

Now, here are the links to the other posts in the MoneyBlogNetwork’s Yearend Money Moves Series:

Blueprint for Financial Prosperity – Dumb Year End Money Moves

FiveCentNickel – Clearing Out Your House For Fun and Profit

Consumerism Commentary – Use Your Flexible Spending Account Before It’s Too Late

NoCreditNeeded – Jump Start Your Debt Reduction Using Christmas Gifts and Year End Bonuses

FreeMoneyFinance – Make Your Charitable Deductions Before Year End

MightyBargainHunter – Grab Some Year End Bargains

Get Rich Slowly – Paycheck and Witholding Calculators for Year End Money Moves