How to create a more balanced portfolio

Q: I worked with an adviser to create an asset allocation mix for my investment portfolio. Over the years, some of my investments have grown significantly and now I think I’m over-allocated in some asset classes. Is this bad?

A: This is an excellent question! Effective investing requires diligent portfolio maintenance. You created an asset allocation mix to diversify your investments and serve as a tool to manage risk and volatility in your investment portfolio. If you allow asset classes to stray too far from their target percentages, you could end up with a completely different portfolio that no longer suits your long-term objectives.

In a given period, asset classes such as equities (stocks) and fixed income (bonds) can experience divergent performance. This is desirable. A portfolio holding assets that do not perform similarly (ie,, with low-return correlation) will experience less overall volatility. However, divergent performances also can change the integrity of your portfolio allocation-a condition known as “asset drift.” As some assets appreciate in value and others lose value, your portfolio’s allocation changes. This affects its risk and return qualities.

Rebalancing is the remedy for asset drift and an important part of maintaining a healthy investment portfolio. To rebalance, you should sell assets that have risen in value and buy more assets that have dropped in value. The purpose of rebalancing is to move a portfolio back to its original target allocation. This restores the strategic structure in the portfolio and puts you back on track to pursue long-term goals.

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At first glance, rebalancing may seem counter-productive. Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones? Intuition might suggest that selling previous winners may hinder returns in the future. This logic is flawed, however, since past performance may not continue in the future-and there’s no reliable way to predict future returns.

Equally important is that your original asset allocation reflects your risk and return preferences. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions. Periodic rebalancing also encourages dispassionate decision making-an essential quality during times of market volatility. Moreover, if and when your overall financial goals or risk tolerance change, you have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of emotion and guesswork.

Next: "The more complex the portfolio allocation, the greater the need for maintenance."

In the real world, portfolio allocations are usually complex, incorporating not only fixed income and equity, but also the multiple asset groups within equity investing. The more complex the portfolio allocation, the greater the need for maintenance.

Determining when and how to effectively rebalance requires careful monitoring of performance and awareness of your tax status, cash flow, financial goals, and risk tolerance. Rebalancing may also incur transaction fees and potential capital gains in taxable accounts.

While rebalancing costs are unavoidable, several strategies can help minimize the impact:

• Rebalance with new cash. Rather than selling over-weighted assets that have appreciated, use new cash to buy more under-weighted assets. This reduces transaction costs and the tax consequences of selling assets.

• Whenever possible, rebalance in the tax-deferred or tax-exempt accounts where capital gains are not realized.

• Incorporate tax management within taxable accounts, such as cost basis management, strategic loss harvesting, dividend management, and gain/loss matching.

The key is to develop a structured plan that remains flexible to each investor’s unique blend of goals, risk tolerances, cash flow, and tax status. No one knows where the capital markets are headed, and that’s precisely the point. In an uncertain world, investors should have a well-defined, globally diversified strategy and manage their portfolio to implement it over time. Rebalancing is a crucial tool in this effort.

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Q: Do I really need to incur the expense of hiring an estate planning attorney or can I do this on my own?

A: It is not uncommon for people to attempt to make an estate plan without consulting legal and financial professionals. Many feel like they have a general understanding of estate planning and believe they can do it themselves without paying for professional services. This is a hazardous path to take and can lead to mistakes. Everyone is different, and a general plan you read about online or in a periodical, or learn about from friends and family does not take your unique individual circumstances into account. Working with a professional is worth the added expense to make sure all your needs are being met by your estate plan.

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