20 Feb

Stick To Your Targets

February 20, 2008

In my previous blog entry, I discussed some basic principles of asset allocation. You now have selected the appropriate assets classes and have purchased the right mix of investment vehicles to meet your targets. However, once you’ve implemented your portfolio, the effects of the market will begin to alter the composition of the portfolio you worked so hard to create.

Let’s use an investor with $200,000 who builds a moderate portfolio of 70% equities and 30% fixed income. Assuming equities average 10% growth per year and fixed income averages 5%, the investor’s initial equity allocation of $140,000 grows to $363,000 over a 10 year period. Over that same period of time, the fixed income portion of the portfolio also fulfilled its job description and the 5% average rate of return on the $60,000 initial allocation to fixed income is now $98,000.

The good news for our investor is that his initial investment of $200,000 has now grown to $461,000. It is, however, important to note that the investor’s allocation is now almost 80% in equities because the strategy worked as planned. The risk profile of this investor’s portfolio has now changed and the potential volatility of this “heavier in stock” mix of assets may no longer be appropriate.

One important, but often overlooked, element of managing a diversified portfolio is having a periodic rebalancing process in place. The concept is simple, on a periodic basis review the actual value of each asset class in your portfolio versus the target weightings. If the current value of the assets in a particular class is higher than the target, trim the excess amount by selling investments in the overweight class.  Follow this by purchasing investments in the underweight asset classes to reconstitute your portfolio.

The equity to fixed income ratio is probably the most common segment to be measured. Though it is prudent to monitor your portfolio on several levels; International to Domestic, Large Caps to Small Caps, Growth to Value.

How often you need to monitor your portfolio depends on its complexity, but in most cases quarterly or even annually is acceptable. The critical part is that it is done consistently.  Allow for some deviation from your targets to reduce the amount of transaction costs and taxes generated from rebalancing.

By following this type of process, you can be assured that your portfolio maintains risk characteristics that you are comfortable with. Systematic rebalancing also removes much of the emotion from your investment decisions, helping you sell high and buy low.

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