Portfolios occasionally get away from investors and become financial beasts. You may have one of these creatures in your file cabinet: Your portfolio may be something you started long ago and added to sporadically over the years, never looking very closely at these investments individually after your initial interest or considering how the individual investments work as a portfolio relative to your financial goals and your changing investor characteristics.
Unfortunately, there are no practical or useful mathematical formulas for portfolio management for the individual investor. However, guidelines can be developed to ensure that portfolio monitoring and revision are accomplished on a timely basis.
What triggers a need to revise or rebalance a portfolio? Generally, you should take a long, hard look at your portfolio if:
- There are changes in your investor profile;
- An evaluation of your investments turns up a poor performer, which you then sell;
- There have been a number of successful investments in the portfolio;
- You are a market timer, and there is a change in your expectations for the market.
When You Should Rebalance
The composition of your portfolio—also known as your asset allocation—should reflect your investor characteristics: your risk tolerance, liquidity needs, tax status, holding period and income requirements. Any changes in these characteristics may result in a need for portfolio revisions. For example, in retirement, the portfolio may be called upon to produce more income to supplement a pension. This would necessitate a shift toward higher-yielding common stocks and fixed-income securities.
Changes in your tax bracket—either due to different levels of income or the ever-changing tax laws—may cause you to move your fixed-income investments into or out of municipal bonds. Reduced tolerance for variations in the value of your portfolio or a greater need for liquidity will necessitate a move toward shorter-term fixed-income investments and away from common stocks. While investors do not undergo changes in lockstep as they progress through life, nevertheless there are critical life-cycle points of transition that affect most investors.
While life-cycle changes and financial characteristic changes are unusual and infrequent, performance evaluation should be ongoing. Selling off a poor-performing asset will change the composition of a portfolio. The sell decision can be complicated by tax considerations as well as the need to find a suitable replacement, which is particularly complicated with individual common stock investments. Unless you monitor the performance of your portfolio and sell off holdings when necessary, your portfolio may soon turn into a collection of investment memorabilia.
Ironically, the relative success of some component of your portfolio can also cause problems. If you have determined an appropriate, diversified mix of assets in your portfolio that reflects your investor characteristics, then an increase in value of one investment may distort the composition of the portfolio, changing its emphasis and reducing the effective diversification of the portfolio. For instance, a run-up in value of an international mutual fund can throw off the intended portfolio balance, causing you to be more heavily invested in international investments than you originally planned. At this point, you should rebalance your portfolio, avoiding any tax liabilities when possible. This can be accomplished by using new money generated from salaries, income and capital gains distributions, and from unusual sources such as property sales and inheritances, rather than by selling off assets and reinvesting the money. If it can be avoided, investments should not be sold to rebalance the portfolio, but rather because of poor performance relative to their asset class.
Finally, some investors choose to change their asset allocations in response to changing market expectations. For example, if interest rates are expected to decline significantly, some investors may want to commit more funds to bond investments, particularly long-term bonds, and decrease their position in common stocks. However, this type of portfolio revision—which is simply market timing—requires accurate forecasts of differential movements in the various markets, an activity that, at best, is extremely difficult to do well consistently and that can generate unwanted tax consequences.
All of these points on portfolio monitoring and revision are important, although there is no direct application technique that can tell you exactly what to do and when, which is what most investors seek. Perhaps that is why portfolio planning and management tend to be put aside.
The Question of Asset Mix
Any discussion of portfolio monitoring and revision begs the question that first confronts the individual investor, “What is the optimal mix of investments for me?”
The mix must be just that—a mix: Diversification within an asset class and among classes of assets. Most portfolios should include common stocks, bonds and cash equivalents such as money market funds and savings deposits. Within each of these areas, there should be sufficient diversification to minimize the risk of any single investment. For example, investing directly in common stocks might entail ownership of 10 to 15 different companies in diverse industries, with approximately equal funds invested in each. If adequate funds are not available for this level of diversification, then mutual funds may provide the necessary diversification with their low initial investment requirements.
Even within the stock market, investments should be diversified to capture the different submarkets: large stocks, small stocks and international stocks, for example. While all are common stock investments, they are not perfectly correlated with each other, and, in the case of international stocks, foreign currency transactions and different economies further add to diversification benefits: reduced portfolio volatility.
The tables below offer a series of portfolios as a rough guideline to show how a portfolio might evolve over an individual investor’s life cycle. Each portfolio reflects the investor characteristics that might be termed usual by broad life-cycle stages. These characteristics are summarized in Table 1 and are offered not as a guideline to what should be but instead to illustrate the dynamic financial nature of the average individual investor. The mid-career example is expanded to include a range of risk tolerances to highlight the differences in individual investors at all points. Your portfolio should reflect your particular set of characteristics and should be responsive to changes in these circumstances.
Table 2 offers some asset allocation structures for each life-cycle point in Table 1; these asset allocations should be considered mere illustrations of approaches to portfolio diversification and management. The portfolios trace the evolution of most portfolios from high-risk, low-income combinations of assets to greater emphasis on yield and capital stability. Again, the mid-career situation is expanded to illustrate how differences in individual characteristics can be accommodated through changes in the investment proportions, in this case in response to different risk tolerances.
The cash position should be interpreted as including such investments as short-term certificates of deposit, Treasury bills, money market funds and similar highly liquid, virtually riskless investments. This is a liquidity reserve that pays current rates and is a buffer absorbing unforeseen liquidity needs and preventing the forced sale of more volatile long-term assets such as common stocks.
The bond category can include municipal bonds, government bonds, corporate bonds or mutual funds that hold these securities. A high tax bracket would dictate that these bonds be municipal securities and in some states with high state and local taxes, the bonds should be issued in state. No matter what the nature of the bond investment, keeping the maturities relatively short—in the five-year to 10-year maturity range—ensures that they will capture most of the yield available with less volatility than the longest-term bonds. If individual bonds are purchased, there should not only be staggered maturities, but also broad diversification among issuers to reduce default risk. Of course, U.S. government securities are an exception to the diversification requirement.
The common stock investments can take the form of direct investments or, through mutual funds, indirect investments. For most individual investors, given the cost of transactions and monitoring, the only way to efficiently enter the international market is through a mutual fund. When investing directly in common stocks, diversification is important and should entail at least 10 to 15 different stocks in diverse industries.
Stocks of large companies offer growth with some dividend income while the stocks of small companies, firms with new products generally in emerging industries, offer more growth, less income and more variability. The three common stock market segments, while related, at times move differently, which adds to diversification. Whether in early career or retirement, these three common stock market segments should be represented in the portfolio with no less than a 10% weighting each. Even in retirement, when the tendency is to sell off all common stocks to avoid risk, a minimum of 30% should still be in common stocks even if the emphasis is now on higher-dividend-yielding common stocks. The greatest risk to the retiree is inflation. Bond investments can be ravaged by inflation because they have fixed dollar liabilities and no growth.
These portfolio breakdowns include only financial assets, the assumption being that real estate, owner-occupied housing or investment property, is held and provides diversification in real as opposed to financial assets. To the extent that there are no significant (at least 10% of the financial portfolio value) real asset investments, particularly in retirement, 10% of the portfolio should hold these assets indirectly, in such investments as gold stocks, mutual funds specializing in natural resource stocks, real estate investment trusts (REITs) and the like. These real-asset type of investments both add diversification and reduce exposure to inflation risks. Remember to consider all your financial assets, including employee pension funds, IRAs, Keoghs, etc., as part of your portfolio.
If you have gotten this far, hopefully you have concluded that portfolio management is not that difficult or complicated. It just has to be accomplished continuously throughout your investment career. As you do this, keep these summary points in mind:
- Diversify within an asset category and among asset categories.
- Make sure your portfolio composition reflects your changing investor characteristics.
- Monitor your portfolio performance at least quarterly, revise for poor performance whenever necessary.
- Rebalance your portfolio quarterly with new money or proceeds from the sale of investments that perform poorly relative to their investment category; substitute concerns for minimizing transaction costs and taxes for asset mix precision. Try to avoid selling assets just to rebalance.
Don’t put this list in a file folder along with your portfolio and forget about them both.
This article was written by John Markese for the November 1989 issue of the AAII Journal. At the time, Markese was executive vice president and director of research at AAII. He is also a former president of AAII and is currently chairman.