Investing 101: Portfolio Management Made Easy

Investing Advice

The recession of 2007-2009 had a significant negative impact on your investments. Personal Investing: The Missing Manual gives you the tools and insight you need to evaluate and make investments designed to grow over the long term.

How often do you review your portfolio? Many investors start out keeping close track of their investments and reassessing their asset allocation at least once or twice year, following the recommendations of most financial experts.  But once the novelty wears off, many investors tend to neglect their portfolios. Ultimately, that may leave them with the wrong investments for their goals, risk tolerance and investing personality.

How often you should be reviewing your portfolio depends on how you invest. If you use asset allocation to divvy up your portfolio by asset classes, a yearly check-up may be all you need—just like seeing your doctor for your annual physical.

On the other hand, if you own individual stocks, you may want to see how they’re doing every time quarterly reports come out. Significant life events, like marriage, divorce, the birth of a child, or retirement, are signals to revisit your objectives and risk tolerance, and possibly revise your target asset allocation.

Why Diversify?

Commuting in a car with four wheels is easier and more stable than riding a bicycle, which is more dependable than a unicycle, which is preferable by far to using a pogo stick.

By owning different types of investments, you ensure that your overall portfolio doesn’t zigzag wildly. Some investments do well in environments that put others into a tailspin. For example, high interest rates mean more income for investors who buy and hold bonds, but high rates typically drag stock prices down. That’s because investors would rather buy bonds, which are less risky than stocks, when bonds deliver a return that’s close to that of stocks.

With a mixture of asset classes, your portfolio returns from year to year are more consistent.

If you buy individual stocks or bonds, diversification means no one investment can seriously harm your portfolio. Regardless of how thoroughly you research investments, some do better than you expect, some do worse, and most perform about on target. If you own one stock and it drops 50%, you lose 50%. If you own 10 stocks and one drops 50%, your portfolio loses only 5%. If another one of those 10 stocks does spectacularly well, you may still come out ahead.

Check Your Asset Allocation

Sticking to your target asset allocation requires occasional portfolio maintenance. Asset classes and individual investments perform differently, which can unbalance your asset allocation. An off-kilter asset allocation can mean unacceptable returns or unpalatable risk.

Say you have $100,000 in your portfolio and have chosen an asset allocation of 60% in stocks and 40% in bonds. After one year, your stocks increase 11% to $66,600, while bonds increase 4% to $41,600. Your new allocation is 61.5% stocks and 38.5% bonds—still close to your target. However, after several years of returns like that, stocks could grow to 70% of your portfolio, while bonds drop to 30%, which may be a riskier allocation than you had in mind.

When you review your portfolio, don’t drive yourself crazy reallocating if your asset classes are a few percentage points off-target. Maintaining a meticulously accurate allocation leads to turnover, which increases your fees, commissions, and taxes. Instead, keep your allocations within, say, 5% of your target. For example, if your target stock allocation is 60% and your actual allocation is 61%, leave it alone. If the actual stock allocation grows to 66%, it’s time to rebalance.

Check Up on Funds, Stocks, and Bonds

In addition to your asset allocation, you need to keep an eye on the investments you own:

  • Index mutual funds. Make sure that fund expenses remain low.
  • Actively managed mutual funds. Review the fund’s returns, expenses, turnover, portfolio, and management.
  • Stocks. If you buy individual stocks, check up on their performance and financial measures.
  • Bonds. For individual bonds, look for rating changes.

Rebalancing Your Portfolio

Bringing your portfolio back into balance means taking money out of the investments that grew faster and buying more of the investments that didn’t keep pace. Remember, some investments simply don’t grow as fast as others; for example, the average bond return is lower than the average stock return (see the table below).

So, when stocks have been on a roll, you have to move money from stocks to bonds to keep your asset allocation percentages on target. Likewise, if small-company stocks have fallen more than large-company stocks, you rebalance your allocation to put more in small company stocks, because eventually their returns are likely to catch up and pass those of large stocks. You can rebalance your portfolio several ways, depending on your circumstances:

* When you have taxable and tax-advantaged accounts

Reallocate in your tax-advantaged accounts first. That way, you don’t have to pay taxes on your capital gains.

In taxable accounts, sell funds before they make their annual distributions, and buy funds after their distributions, so you don’t have to pay taxes on gains and dividends.

* When you no longer contribute to your portfolio

You have two ways to reallocate a portfolio to which you no longer make contributions. One option is to sell some of the over-allocated investments and to use the proceeds to buy more of the under-allocated ones. For example, the worksheet below shows that long-term bonds are 2% ($2,000) above their target and that small stocks are 8% ($8,000) above their target. The negative numbers in the +Buy/–Sell column tell you how much you would have to sell to bring them back on track. At the same time, large stocks are 10% ($10,000) below target. You could sell $2,000 worth of long-term bonds and $8,000 of small stocks to purchase the $10,000 of large stocks you need. You can download the Portfolio_Rebalancing.xls spreadsheet here (¾ of the way down the page).

If you’re withdrawing money from your portfolio, the other way to rebalance is to sell portions of your better performers for your withdrawals.


* When you still contribute to your portfolio

If you continue to add money to your portfolio, you can use dollar-cost averaging to rebalance it. Invest your new contributions in the investments or asset classes that have fallen below their target allocations. That way, you simply add more money to the investments that fell behind instead of selling your better performers. For example, in the portfolio above, you could invest your $1,000 monthly contributions in large  stocks until they reach their target allocation.

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