So the stock market has slumped a bit recently, but not enough to shake the faith of true believers. After all, where else are you going to get a decent return? Not in bonds. Not in bank savings...
Still, an all-in commitment to stocks is probably too risky, except perhaps for 20- and 30-somethings with decades to overcome downturns. Other investors are wise to stick to the optimal mix of stocks, bonds and cash they've plugged into the master plan. And, after the kind of run-up stocks have enjoyed lately, with the Standard & Poor's 500 up about 15 percent over the past year and investors buying into stocks to take advantage, that now means shifting some money from stocks to other holdings.
"It has been particularly easy to ignore experts' admonitions to rebalance over the past few years," says Christine Benz, Morningstar's director of personal finance. "Even though many investors' equity allocations blew past their target weightings a few years ago and stock valuations haven't looked cheap for a while, a policy of benign neglect has been not just psychologically comfortable, it has also been the winning portfolio strategy."
Now it's time to think about rebalancing and returning risk to acceptable levels.
While the basics of rebalancing are simple -- get back to the desired percentages of each type of holding -- the decisions can be tricky. So Benz has a list of six rebalancing tips:
Investors can reduce rebalancing unpleasantness by doing much of the work in tax-favored accounts such as 401(k)s, Benz notes. That way, sales of stocks or stock funds will not trigger tax bills on capital gains, as they might if conducted in taxable accounts. Also, asset shifts in 401(k)s and similar plans typically involve little or no transaction costs. So long as the investor's total holdings adhere to the desired asset mix, it's not necessary that they follow the same guidelines within the 401(k).
Second, investors are wise to dig down and take a surgical approach, Benz advises. Asset allocation involves subcategories such as large-cap stocks, small stocks and foreign stocks, as well as different types of bonds. Since many mutual funds contain a variety of subcategories and market sectors, it's too easy to end up over- or underweighted in certain types of holdings. Tools such as Morningstar's Instant X-Ray can help investors explore the depths.
Third, don't overlook potential problem areas such as a big allocation of your employer's stock, which is easy to accumulate if you participate in a stock-purchase plan. If you work for a financial company and want to keep your company shares, considering trimming financial stocks elsewhere in your portfolio.
Fourth, beware of "faux diversification," which, for example, could occur if you move out of stocks and into bonds that are just as risky, such as high-yield or emerging-market bonds.
Fifth, rebalance with an eye to other financial moves. Retirees, for instance, can reduce stock exposure by selling and using the proceeds for living expenses, rather than buying other assets.
Finally, don't feel you have to rush. Even if your portfolio is dramatically out of balance, chances are the new assets you buy will contain some risk too, so it's not as if an overnight move will make your portfolio risk free. Benz notes, however, that an investor about to retire might be wise to cut back on risk at a deliberate pace over no more than a few months.