Time to tweak your portfolio

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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NEW YORK (Money) -- Question: I want to better diversify my portfolio. So I'm thinking of getting rid of some funds that focus on specific industries or geographic areas and investing in funds with broader holdings. The problem is that the funds I want to get rid of tanked hard in 2008. Would it be better for me to hold onto them until the sector recovers? Or should I sell them and create a more diversified portfolio right now?  Josef Werne, Duluth, Minnesota

Answer: I first want to applaud you for adopting an approach using more broadly diversified funds.

While I know that it's possible to build a fully diversified portfolio by assembling "niche" funds or ETFs, and create your very own version of an index fund like the S&P 500.

But I put this approach in the "theoretically possible, but realistically hard to achieve" category. One practical problem: In what proportions should you own the various parts? Do you give, say, financials a larger share of your homemade S&P portfolio than the financial sector gets in the actual index? Do you give it a smaller share? Do you omit any sectors? And how do you decide?

The market value of a sector represents the market's consensus of the relative worth of that sector. If you're going to own it in a different proportion than you would get it by buying the S&P 500 itself, you're essentially saying you have more insight into the value of the sector than your fellow investors do.

If you really do, fine. But I find that most individuals' purchase of sector and narrowly focused funds represent not a well-considered view of the capital markets, but a hunch. And hunches have a way of backfiring.

Once you decide to go with broader funds, there are any number of ways you can adopt that approach. The easiest is to buy a simple combination of very broadly diversified funds. Owning a total U.S. stock market index fund and a total U.S. bond market index fund would give you the entire U.S. market in just two funds.

If you want to get a little fancier, you could throw in a total international stock index fund, which would give you exposure to foreign developed and (depending on the fund) emerging markets.

Or you could assemble the same or a similar portfolio by mixing and matching domestic large-cap and small-cap index funds and foreign developed and emerging market index funds (or even actively managed funds). But then you run into the issue of how to divvy up your money between large- and small-caps, developed and emerging markets. I like to keep things simple, which is why I think it's a better idea to stick with the more comprehensive funds.

Whichever approach you want to take, you can pull it off by checking out the index and actively managed funds in our Money 70 list of recommended funds.

Now to the timing issue you asked about: Do you jettison your sector funds now, take the loss and rebuild your portfolio? Or do you hold off until your funds recover?

I know that many people find it hard to sell a fund, or any investment for that matter, at a loss. It's like you're officially admitting a mistake. So there's a powerful emotional appeal to holding on until you get even.

But that's the wrong way to look at the situation.

As an investor, your focus should be toward the future, not the past. The real issue you want to address is whether you've got the right portfolio of assets to give you the best return looking ahead.

Fixating on getting back to even in any single investment could prevent you from putting your money where it may generate a better return. So your aim should be to assure you own a portfolio of assets that will deliver solid gains in the future (which, by the way, will also help you recover your losses).

So if you have determined, as you apparently have, that your present portfolio really isn't right for you, then you need to get to one that is. And, ideally, you don't want to procrastinate about doing it. After all, you would only be leaving your money invested in a portfolio that you consider flawed, which makes little sense.

That said, there could be other issues you need to take into account when making changes in your portfolio. If your investments are held in a taxable account, then taxes may come into play. But that's mostly an issue if you're selling off investments in which you have big gains that would trigger a tax liability. In such a scenario, you might want to get out of the investment gradually, or try to time sales to coincide with losses in other investments.

In your case, it sounds as if the funds you want to unload may be selling for less than you paid for them. So even if you have gains in some other funds that you need to sell, you may be able to minimize or even eliminate the tax hit with realized losses in your sector funds.

Of course, if you're holding these funds in a tax-advantaged account like a 401(k), IRA or Roth IRA, then you don't need to worry about the tax effect of selling the funds and reinvesting the proceeds.

Bottom line: Don't obsess about recovering losses in funds you no longer feel are appropriate for your investing strategy. Just figure out what sort of portfolio you really want to have -- i.e., the right mix of stocks vs. bonds and the specific funds you want to create that blend. And then sell what you need to sell and buy what you need to buy to create that portfolio as soon as you reasonably can.