Your portfolio: Tame the mix

NEW YORK (Money) -- Question: I contribute 15 percent of my salary to my 401(k) and put money into an IRA and a taxable investment account, but I don't have much investing experience. I've heard that I should rebalance my portfolio each year, but I'm not sure how to do that.

How do I know whether I need to move money from one sector to another, say, from large-cap to small-cap stocks, and how do I go about doing this? - Soni, Chicago, Illinois

Answer: Rebalancing is one of those exercises that most people know they ought do - or, like you, have heard they should do - but somehow never seem to get around to doing. And that's a shame. Because if you're not periodically re-adjusting the mix of assets in your 401(k) and other retirement accounts, you're letting the ups and downs of the various sectors of the market do it for you.

Which means your chances of maintaining a portfolio that reflects your personal preference for risk vs. reward are low at best. Fortunately, rebalancing doesn't require much time or effort. You don't have to be a fanatic to do it successfully.

In fact, I believe the simplest approach is probably the best. And there even are ways to assure your retirement portfolio gets rebalanced without you having to do much of anything. But before we get into the mechanics of rebalancing, let's do a quick review of the rationale behind the concept.

When you set up your 401(k) and other retirement accounts, your single most important decision is how to divvy up your money between stocks and bonds and then, within those broad categories, how to spread your stash among large-cap stocks, small-caps, international stocks and investment-grade vs. high-yield bonds.

You can read about the finer points of this process by checking out our Money 101 lesson on Asset Allocation, but the idea is that the longer you have until you retire, the more you should be concerned about growing your retirement accounts versus protecting them from short-term setbacks. So the more you should be investing in stocks.

To keep things simple, let's assume you decide to invest 35 percent of your retirement stash in large-company stocks, 20 percent in foreign shares, 20 percent in small-caps and 25 percent in bonds. As returns for different investments vary over the course of a year, those percentages are going to change.

If large-company stocks have a run and small-caps don't do so well, the big boys will account for a larger percentage of your portfolio at the end of the year compared with the small fry. And if stocks take a hit and bonds go on a roll, then bonds will become a larger share of your holdings.

So to your first question, how do I know whether I need to rebalance, the answer is simple: Just take the balance of each asset class you own - large-cap, small-cap, etc. - and divide it by the total value of your portfolio. Then compare the percentages to the original percentages you set.

So, for example, if large-caps have gone from 35 percent of your portfolio's value to, say, 40 percent, then you know you've got to scale back your large cap exposure. And, of course, since the percentages of all your different asset classes have to add up to 100 percent, then an increase in the percentage of one sector means that one or more of the others have changed as well and thus may also need to be adjusted back to its original setting.

It would be a rare year that the various asset classes in your 401(k) and other retirement accounts would represent the same percentage of your overall portfolio at the end of the year as they did at the beginning. More likely than not, some holdings are going to shrink relative to the others and some are going to grow.

You might just figure, big deal - does that even matter? The answer is yes because if big gains in the stock portion of your holdings push it to, say, 85 percent of your portfolio's value from 75 percent while the bond portion shrinks from 25 percent to 15 percent, then you've got a significantly riskier portfolio on your hands.

If at the same time, the small-cap portion of your stock holdings zooms to 30 percent, then you would have an even more volatile portfolio because small stocks tend to jump around more than large ones.

Conversely, if stocks take a big hit and bonds swell in value to, say, 35 percent of your holdings, then you would have a much more conservative portfolio.

Either way, the mix of assets in your retirement accounts at the end of the year wouldn't reflect the trade off between risk and return that you set in the beginning of the year. In short, your portfolio would no longer fit you.

So the question is, how often do you tweak your retirement accounts to get the proportions back in synch, and how do you go about doing that? You've got three basic choices.

One is to bring your portfolio back to its target proportions whenever one or more of your holdings - large stocks, small shares, foreign investments, whatever - strays more than, say, five percentage points from where you want it. I think this approach makes sense, but it requires you to monitor your holdings on a regular basis, and could mean making several moves over the course of a year, which, in the case of taxable accounts, could trigger taxable gains.

The second way to go is to adopt what's sometimes called a tactical rebalancing strategy. If your portfolio's proportions stray from their original settings, you first consider the outlook for the financial markets before deciding whether to move back to your original mix. If stocks have become a larger portion of your holdings but you think the market still has room to run, then you might forego any fine tuning.

On the other hand, if you believe the market may be poised for a setback, then you might go back to your original stocks-bonds mix, or even tilt more toward bonds. I don't like this approach because it smacks of market timing and, to my mind, undermines the purpose of setting an asset allocation strategy in the first place. I mean, if you really think you can tell which asset classes are going to do better in the future, why spread your money around at all?

The third choice - and the one I like most - is to rebalance at pre-set periods. You could choose almost any time frame you want - monthly, quarterly, semi-annually, etc. - but I think once a year makes the most sense for two reasons.

First, it gives asset classes that are doing well at least a little bit of time to rack up some gains. Second, it's probably the easiest method of the three. You just pick a date you'll remember - your birthday, New Year's Day, whatever - and rebalance on that day each year. If something is simple and easy, you're more likely to do it.

As to the question of how to bring your portfolio back to its original proportions, I've got a few suggestions. First, you should think of all your retirement investments as one large portfolio that includes both tax-advantage accounts (401(k)s, IRAs and the like) as well as taxable accounts earmarked for retirement. And your target mix of assets should apply to these assets as a whole.

So if you decide that, say, 75 percent of your retirement investments should be in stocks, that means 75 percent of all your retirement assets. When you're rebalancing, however, you should try to limit your adjustments as much as possible to your tax-advantaged accounts. The reason is that moves within those accounts won't generate any taxes.

So, for example, if your portfolio overall has become overweighted in large-cap stocks and underweighted in small-caps and bonds, you would ideally want to sell enough large-cap stocks or funds in your 401(k) and/or IRA accounts to bring that class back to its target percentage and plow the proceeds into your small-cap and bond holdings to restore them to their original proportions.

If that's not possible, then you should at least consider making your moves in a way that creates the smallest tax bill. You might sell shares of a stock or fund that have the highest cost and thus might result in a smaller gain or even a loss. Or you might sell shares you've held longer than a year so any gain would be taxed as a long-term capital gain. (For more on making adjustments within taxable accounts,click here.)

If only minor changes are needed to restore your retirement portfolio's mix, you can probably just put new contributions into whichever asset class has been lagging and thus needs to bulk up its presence. As I mentioned earlier, you don't have to be a fanatic about this.

If your portfolio's proportions are off by only a couple of percentage points, you can probably just let things ride. Having 22 percent of your money in foreign shares vs. 20 percent isn't going to wreak havoc on your investing strategy. But even if this once-a-year routine is too much for you, there are options that require virtually no effort from you.

You can sign up for automatic rebalancing at many 401(k) plans these days. If your 401(k) offers this option - which you can find out by checking with your HR department or the investment firm that manages your company's plan - it's an easy way to assure that your 401(k) account maintains the proper proportions.

Of course, if you have sizeable balances outside your 401(k), you'll still need to check the allocations in those accounts. But the ultimate hands-off solution is to invest in a target retirement fund. These funds are fast becoming the most popular choices in 401(k)s, although they're also available outside employer-sponsored plans.

Target funds give you a mix of different types of stocks and bonds that's appropriate for your age. And they automatically rebalance the fund's holdings not just to compensate for varying returns in different asset classes, but so that the blend of assets becomes more conservative as you near retirement. For more on these funds and how they work, click here.

So I suggest that you pick a rebalancing date now and put it on your paper or digital calendar. Or, if you think that rebalancing is just one of those tasks that you know you'll never get around to, then see whether automatic rebalancing or a target fund is an option in your 401(k) plan.

Or you could do nothing, in which case the financial markets will do your rebalancing for you. Just don't expect them to get it right.