My Annual Investment Portfolio Tune-up: Rebalancing

Yesterday we looked at building an asset allocation plan. We walked through my asset allocation plan as a guide, but you'll obviously need to make investing decisions that are best suited for your situation. Today, I'm going to layout all of my investments, compare them to my asset allocation plan, and then discuss any rebalancing that needs to occur. So let's start with my investments grouped by asset class, along with my actual percentage and planned percentage that each class represents:

The table organizes the funds based on the primary asset class of each fund. It's important to understand, however, that most mutual funds can and do invest beyond their stated objective. For example, a small cap fund may invest a portion of its assets in mid cap or even large cap companies. And almost all funds hold some amount of their assets in cash, either as they wait for investing opportunities or to have cash available to pay selling shareholders. I've written on this in some detail, and you can read about it in Don’t Judge A Mutual Fund By Its Name.

If you want to get a more accurate picture of your actual asset allocation, you can use Morningstar's free and premium tools. Morningstar's X-Ray tool, for example, can break down a portfolio into a more detailed description of the various asset classes. I generally don't think such precision is necessary.

Returning to the table of mutual funds, note that by clicking on the name of each fund, a separate window will open in your browser and take you to the Morningstar Snapshot for each fund. You'll also note that for each asset class I'm slightly under my plan with the exception of U.S. Large Cap funds, where I'm over my asset allocation plan by nearly 8%, or about one-half of my planned allocation. That's a significant variance and requires some explanation.

Because many of my investments are in taxable accounts, I have to consider the tax implications when I sell shares of a fund to rebalance my investments. As a result, I'll sometimes allow an asset class to vary from the plan in order to avoid the tax implications of a sale. In this case, I've been comfortable allowing U.S. Large Cap funds to exceed my plan. I wouldn't be as sanguine if it were a riskier investment, like emerging markets, for example. In fact, earlier this year I took a tax hit to sell some of my Vanguard Emerging Market fund because it was at about 13%. While that's only 3% over my target, emerging markets present significantly more risk, in my view, than U.S. large cap companies.

So to get my investments back to plan, I'll do two things in 2008. I'll continue to direct 50% my contributions to FIREX (an international REIT fund) to slowly increase my REIT exposure to 10%. And I'll direct 50% of my contributions to PTTRX, a well diversified, intermediate term bond fund. In addition, I intend to transfer my current investment in Vanguard's high-yield corporate bond fund to Vanguard's TIPS fund. The purpose of my bond investments is to achieve some level of stability to my portfolio, and a high yield corporate bond fund doesn't achieve that objective.

So with those relatively minor changes, my portfolio should be ready for 2008, at least as far as asset allocation is concerned. In the next article in this series, we'll look at my portfolio's performance in 2007 and see how it stacks up to various benchmarks.