4 Steps To A Perfectly Balanced Portfolio

posted on 06-07-2019

Does the idea of buying and selling assets strike fear in your heart?

We've all been stuck in inaction at some point when it came to purchasing or selling investments.

Is that booming market the wrong time to buy?

Or there's the other way around: Has the market dropped too much to justify selling?

Well, there is a way to minimize the anxiety and boost your portfolio. It's really quite simple: It's called rebalancing your asset allocations, and I'm going to tell you how to do it in a minute.

Some studies say 90% of an investor's returns are attributed to a portfolio's asset allocation. Whether that percentage is accurate or not, there is little dispute that one's asset allocation is an important factor in the investor's long-term rate of return.

Money Magazine recently reported that the investor can boost returns by almost 1% by rebalancing every year or so. 

So, you know you need to reallocate, and you know it will benefit your portfolio. But do you know where to begin? Let's look at the hypothetical Jenae Doe's situation.

This is the allocation Jenae Doe determined meets her potential risk and return combination. Take a look at Jenae's optimal portfolio and find out how easy it is to rebalance.

Jenae's Desired Asset Allocation
Fund Type % Of Portfolio
Total U.S. Stock Index Fund 30%
All-World ex-U.S. Stock Index Fund 20%
Government Bond Index Fund 20%
Corporate Bond Index Fund 20%
REIT Index Fund 10%


Step 1: Schedule rebalancing on your agenda, or it will never happen!

In early January, "rebalance asset allocation" came up on Jenae's calendar. Here's how her asset allocation looked before rebalancing.

Jenae's Holdings Prior To Rebalancing
Fund Type % Of Portfolio
Total U.S. Stock Index Fund 35%
All-World ex-U.S. Stock Index Fund 13%
Government Bond Index Fund 22%
Corporate Bond Index Fund 21%
REIT Index Fund 9%


It's easy to see that the asset allocation one year later is not the same as the optimal target percentages.

Step 2: Compare current asset allocation with target asset allocation percentages.

Jenae needed to get her asset allocation back to her predetermined percentages. This is where the Asset Allocation Rebalancing chart comes into play. The chart -- which lists your target allocation and your current allocation side by side -- is designed to help you determine just what moves you need to make in order to get where you want to go.

Below is Jenae's chart, with two of the three columns filled in.

Asset Allocation Rebalancing Chart
Fund Type Target % Current % Buy Or Sell?
Total U.S. Stock Index Fund 30% 35% ?
All-World ex-U.S. Stock Index Fund 20% 13% ?
Government Bond Index Fund 20% 22% ?
Corporate Bond Index Fund 20% 21% ?
REIT Index Fund 10% 9% ?


So now you've laid out your current holdings and your optimal holdings side by side. Now, it's on to Step 3....

Step 3: List the securities to buy and sell.

Complete the buy or sell column by calculating the difference between the current asset allocation and the target in the "Buy or Sell" column.

For example, the predetermined target is Total U.S. Stock Index Fund –- 30%. At the end of the year the asset percentage in Total U.S. Stock Index Fund is 35%.

So that means that you need sell enough of that index fund to equal 5% of your portfolio. That then gets put into the final column of the chart, like this... 

Asset Allocation Rebalancing Chart
Fund Type Target % Current % Buy Or Sell?
Total U.S. Stock Index Fund 30% 35% Sell 5%
All-World ex-U.S. Stock Index Fund 20% 13% Buy 7%
Government Bond Index Fund 20% 22% Sell 2%
Corporate Bond Index Fund 20% 21% Sell +1%
REIT Index Fund 10% 9% Buy 1%


One thing to clarify here. You're not selling 5% of your holdings in that index fund. Instead, you're selling a portion of your holdings in that fund that is equal to 5% of your total portfolio. It's a nuanced, but important distinction...

For example, say the previously mentioned index fund is in a $100,000 portfolio. To make up 35% of that portfolio, you would need to have $35,000 in that index fund. If your goal is to reduce that percentage to 30%, you would need to have just $30,000 invested in that fund -- meaning that you would need to shift $5,000 (5% of your total portfolio) from that fund into another holding. 

There are a couple of ways to tackle the next step. One option is to put new monies into undervalued categories. Another approach is to sell the overvalued assets and buy the undervalued ones. Or, Jenae could do a combination of both strategies.

Step 4: Sell or buy the percent of the over or undervalued holding.

You anxiety may increase a bit on this one, as there's a bit of fear when one buys and sells a security. There's that little voice that says, "What if I'm making a mistake?"

That's the nice part about predetermining an asset allocation. You've made your investment decision already, and in this step, you are just following up with a predetermined decision.

In the case of Jenae, she will sell enough of the Total U.S. Stock Index Fund to return to her 30% target. She continues by selling parts of her U.S. Government Bond Fund holdings equaling 2% of her total portfolio and parts of her Corporate Bond Fund holdings equaling 1% of the total portfolio. (Hint: Sometimes if the percentages are only off a little, you may elect to do nothing.)

Next, she'll buy enough of the All World ex-U.S. Stock Index Fund to equal 7% of her total holdings, and either do nothing or buy shares of the REIT fund totaling 1% of her portfolio's total holdings.

As mentioned in Step 3, Jenae could elect to add new monies to the under allocated category such as the All World ex-U.S. Stock Fund and the REIT Fund until target allocation is reached. This is a more gradual approach than the buy and sell method to reach optimal asset allocation.

The Investing Answer: Once your portfolio is rebalanced, you don't need to do anything for another year. Check it a few times a year, but if you accurately determined your initial asset allocation, then there's no need to overmanage or overanalyze your investments.

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