Portfolio Management

Re-Allocating Your Portfolio: Timing a Transition

How do I implement a transition to my portfolio?

Change is inevitable. For instance, you become more risk-averse—there will be times when a change in your investor profile will prompt you to rethink your portfolio's allocation. Suppose your portfolio's current asset allocation is 56.5% in stocks (34.5% in large-cap stocks, 15.0% in small-cap stocks, and 7% in foreign stocks), 18.5% in bonds, and 25% in cash, and is invested as follows:

Balanced Fund (60% stocks; 40% bonds) 15.00%
Large-Cap Growth Fund 7.50%
Small-Cap Fund 9.00%
Total Return Fund 8.50%
International Fund 7.00%
Bond Fund 12.50%
Money Market Fund 25.00%
Individual Stocks (Large) 9.50%
Individual Stocks (Small) 6.00%

Let's assume that you have re-evaluated your circumstances and risk tolerance, and you've decided that you are undercommitted to stocks. You would like your mix to be much more aggressive: an 80% commitment to stocks (45% of the portfolio in large-cap stocks, 20% in small caps, and 15% in foreign stocks), 10% in bonds, and 10% in cash.

How do you make the transition?

First, you must determine which funds or stocks to emphasize or add, and which to de-emphasize. Does it make sense to add new mutual funds to reach your goal? If there are no funds that you currently own that will help you meet your new allocation goals—if, for instance, you wanted to add foreign stocks and didn't currently own a foreign fund—it would make sense to add a new fund to your holdings. Or, if there is a different fund that you prefer to an existing fund, you may want to add that fund.

However, there is no reason to "diversify" among funds of similar type. The portfolio itself is diversified. Adding funds that are in similar categories can be counterproductive, creating a closet index fund—in other words, the combination of similar funds performing like an index fund, yet at the higher cost of active management, reflected in higher expense ratios.

In this example, we'll assume that you've decided you are happy with your existing funds and stocks, and will work within your current holdings.

Given the desired asset allocation, it is clear that you need to add funds to all three stock categories—large caps, small caps, and foreign.

To meet your large-cap target, committing more funds to the balanced fund would make no sense, since that would also add to your bond commitment. In addition, the Total Return Fund tends to time the market, which means that at any given time, your funds may or may not be committed to stocks, so it would make little sense to add to this fund. Thus, you decide to add to the Growth Fund for your large-cap portion.

How much? Your desired allocation to large-cap stocks is 45%, and your large-cap holdings aside from the Growth Fund total 27% (8.5% in the Total Return Fund, 9% in the Balanced Fund, and 9.5% in individual stocks); that implies an 18% addition (45% - 27%) to the Growth Fund. To calculate the amount you need to add to the Growth Fund, simply multiply your total portfolio value by 18% and subtract your current Growth Fund value from the result. For example, if your total portfolio value is $200,000 and the Growth Fund is currently worth $15,000, your 18% target is $36,000, and you would need to add $21,000 to the Growth Fund to bring it up to that level [($200,000 x 18%) - $15,000]. Use this strategy with each category.

Remember to consider tax liabilities that you may incur when withdrawing from the Bond Fund.

If you are retired and living off of your retirement assets, simply withdraw from the targeted investments.

In addition, you may want to consider the addition of new money generated from salary, income, and capital gains distributions, or one-time sources such as an inheritance. Make sure you are reinvesting distributions from existing funds to the new targets and do not reinvest in those you want to de-emphasize.

Don't worry about pinpoint accuracy when moving to a new asset allocation strategy. Your portfolio mix will be constantly changing with the markets and you should monitor it periodically (quarterly or semiannually). Use new money to fine-tune your portfolio rather than selling taxable assets in order to reach an accurate asset allocation mix. Substitute concerns for minimizing transaction costs and taxes for asset mix precision, and don't worry about straying from your targets by several percentage points.

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How quickly should the transition be accomplished?

It is impossible to predict with accuracy when the best time is to invest in any of these investment categories, and attempting to do so can easily backfire, resulting in an investment at the worst possible time. Moving large amounts of money from stocks to bonds, or the reverse, should be done gradually, in roughly equal payments over a two-year period, to reduce the market impact at one point in time.

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How frequently should the moves occur?

Markets can change dramatically over the course of a year, and for that reason yearly changes are too infrequent. Monthly is an alternative, although for some it may be overly cumbersome, particularly for sales, which may result in complex tax computations. Quarterly changes are probably the easiest to accomplish, spreading the transition over various market environments without being overly burdensome.

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Asset Allocation Influences

What different conditions will affect my asset allocation?

Here's a rundown of the major conditions affecting asset allocation decisions, and how they may change over time.

Risk Tolerance: Risk refers to the volatility of your portfolio's value. The amount of risk you are willing to take on is an extremely important factor because investors who take on too much risk usually panic when confronted with unexpected losses and abandon their investment plans mid-stream at the worst possible time. While some people do become more risk averse as they get older, risk tolerance is not necessarily a function of age; a conservative investor will go through changes in asset allocation over his life cycle, as will an aggressive investor.

Return Needs: This refers to whether you need to emphasize growth or income. Most younger investors who are accumulating savings will want returns that tend to emphasize growth and higher total returns, which primarily are provided by stocks. Retirees who depend on their investment portfolio for part of their annual income will want returns that emphasize relatively higher and consistent annual payouts, such as those from bonds and dividend-paying stocks. Of course, many individuals may want a blending of the two--some current income, but also some growth.

Investment Time Horizon: Your time horizon starts when your investment portfolio is implemented and ends when you will need to take the money out. The length of time you will be invested is important because it can directly affect your ability to reduce risk. Longer time horizons allow you to take on greater risks, with a greater total return potential, because some of that risk can be reduced by investing across different market environments. If your time horizon is short, you have greater liquidity needs—the ability to withdraw at any time with reasonable certainty of value. Volatile investments such as stocks lack liquidity and require a minimum five-year time horizon; shorter maturity bonds and money market funds are the most liquid.

Time horizons tend to vary over your life cycle. Younger investors who are only accumulating savings for retirement have long time horizons, and no real liquidity needs except for short-term emergencies. However, younger investors who are also saving for a specific event, such as the purchase of a house or a child's education, may have greater liquidity needs. Similarly, investors who are planning to retire, and those who are in retirement and living off of their investment income, have greater liquidity needs.

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How can I use my investment profile to determine an allocation for my portfolio?

Once you have assessed your personal profile, you will need to match the investment characteristics of the various asset categories to your risk and return characteristics in an efficient manner that maximizes return while minimizing risk. Diversifying among the asset categories reduces individual category risks and allows you to build a portfolio that matches your investment profile.

AAII's First Steps Investor Classroom uses historical data to illustrate how you can divide your assets between stocks, bonds and cash based on your risk/return profile.

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What is diversification and why is it important?

If you invest in a single security, your return will depend solely on that security; if that security flops, your entire return will be severely affected. Clearly, held by itself, the single security is highly risky.

If you add nine other unrelated securities to that single security portfolio, the possible outcome changes; if that security flops, your entire return won't be as badly hurt. By diversifying your investments, you have substantially reduced the risk of the single security. However, that security's return will be the same whether held in isolation or in a portfolio.

Diversification substantially reduces your risk with little impact on potential returns. The key involves investing in categories or securities that are dissimilar: Their returns are affected by different factors and they face different kinds of risks.

Diversification should occur at all levels of investing. Diversification among the major asset categories—stocks, fixed-income and money market investments—can help reduce market risk, inflation risk and liquidity risk, since these categories are affected by different market and economic factors.

Diversification within the major asset categories—for instance, among the various kinds of stocks (international or domestic, for instance) or fixed-income products—can help further reduce market and inflation risk.

And diversification among individual securities helps reduce business risk.

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What is the benefit of time diversification?

Time diversification, remaining invested over different market cycles, is extremely important yet often overlooked.

Time diversification helps reduce the risk that you may enter or leave a particular investment or category at a bad time in the economic cycle. It has much more of an impact on investments that have a high degree of volatility, such as stocks, where prices can fluctuate over the short term. Longer time periods smooth those fluctuations. Conversely, if you cannot remain invested in a volatile investment over relatively long time periods, those investments should be avoided. Time diversification is less important for relatively stable investments, such as certificates of deposit, money market funds and short-term bonds.

Time diversification also comes into play when investing or withdrawing large sums of money. In general, it is better to do so gradually over time, rather than all at once, to reduce risk.

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Portfolio Manager Change

Should I switch out of a fund if the portfolio manager changes?

No. The change of a portfolio manager is not reason, in and of itself, to leave a fund. Instead, monitor the fund closely to make sure the new manager is continuing the old manager's style, and that any changes won't significantly affect your investment. New portfolio managers have been known to take command of a fund and sell off securities, reflecting a change in style. A significant portfolio realignment might mean greater capital gains distributions, and therefore taxes, unless you hold the fund in a tax-sheltered account. On the other hand, if the fund is an index fund or less actively managed, the portfolio manager may not be all that important. Or the new portfolio manager may continue with the old style and perform just fine.

Switch to a fund with a similar investment objective only when the performance of your fund falls off against other funds with the same investment objective, or if your existing fund changes objectives so that it no longer reflects the objective you are seeking.

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Life-Cycle Investing

How should I change my investing habits as my needs change?

Your personal investment profile will change over time. For instance, your tolerance for risk may change as you get older, or as you acquire more assets and become more financially secure. When you approach retirement, your time horizon may shift, and become a blend of long-term and intermediate- or short-term needs. As it does so, you will need to make revisions to your investment plan to reflect these changes.

The table shows how an investor's profile may change over time. The table also illustrates the degree to which profiles can vary.

Of course, your own profile may be very different than the one presented here; your profile may even fit one of those listed here, such as early retirement, even though you are in a different stage-perhaps early career. The table is only an example.

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An effective investment portfolio is one that is based on a balance between the risks you are willing to take and the returns you need to achieve your goals. An understanding of the various aspects of your investment profile will allow you to assess that proper balance.

The next step is to match the investment characteristics of the various asset categories to your risk and return characteristics in an efficient manner that maximizes return while minimizing risk.

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Load vs. No-Load

My fund just imposed a load. Should I bail out?

If your fund imposed a load, you may be grandfathered in and allowed to invest new funds without a load. But if they do charge a load on additional money you want to invest, you are faced with a dilemma. Don't sell on the news that the fund is going to impose a load, but certainly don't commit new money if you will be charged an unreasonable load.

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Fund Family vs. Discount Broker

Should I deal only with the fund family or go through some of the discount brokers that offer mutual funds?

Discount brokers such as Charles Schwab and Fidelity Brokerage offer the convenience of buying different funds without going directly to each fund family and opening separate accounts. Only one brokerage account is necessary, and all mutual fund positions are consolidated in one report. Some of these transactions incur brokerage costs; others are essentially costless.

Not all funds or fund families participate, but if convenience is important and your mutual fund transaction sizes are reasonably large, these fund services offered by discount brokers may deserve a look. For more on buying mutual funds through a broker, see our Brokers page by clicking on the button below.

Certainly these aren't all the questions mutual fund investors have, but they are some of the ones most commonly asked. The fund prospectus has a great deal of information and is always worth reading and studying, but inevitably questions arise that can't be covered by materials produced by mutual funds.

The more you truly know about how mutual funds operate and what contributes to their performance, the less you will be stumped.

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Timing the Market

What's the danger of using a market timing strategy?

The goal of a market timer is to enter the market when it is rising, and exit when it is falling. While the strategy sounds appealing, it is difficult to execute, since no one has been able to devise a system that can tell in advance if the market will rise or fall. Market timers therefore tend to follow the trends, bailing out after the market has started to fall, and jumping in after it has started to rise.

However, the stock market movements are jerky, not smooth, and allow little time for even the most prescient market timer to act. Thus, one of the major risks of this kind of strategy is that it may have an investor out of the market when the bulls stampede.

One study examined the distributions of monthly stock returns for the S&P 500 and small stocks since 1926. The researchers discovered that the best returns on the S&P 500 were concentrated in only a few months. Small stock returns were shown to have been even more concentrated than the S&P returns.

Probably the biggest risk of a market timing strategy is that a few missed bull markets can negate the long-term return advantage stocks have historically provided. And market timing strategies sometimes miss the boat. In recognition of this all too familiar trait, investors should refrain from full-bore timing strategies that require the portfolio to be either 100% in stocks or 100% in short-term debt. Diversifying a portfolio across asset types provides protection that is too certain to be discarded for the uncertain promises of market timing. Timing strategies that call for either an all stock or an all debt portfolio, or almost all stock or almost all debt, contain excessive and unnecessary levels of risk.

If you are interested in market timing strategies, you should at least limit the portion of your total portfolio that is subject to the risks of market timing.

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Calculating Your Return

How do I calculate my return?

Calculating the performance of your total portfolio isn't that difficult if you don't want precision accuracy; the formula is presented below.

If the return isn't within the target range you expected based on your investment mix, you may need to make some adjustments in your future projections. For instance, you may have to increase your savings rate, you may have to take on more risk to achieve the target that you set, or you may simply have to adjust your target value downward, settling for less in the future.

Monitor the performance of the components of your portfolio—mutual funds, investment advisers and self-managed investments—either quarterly or semiannually and judge the results against relevant benchmarks.

The purpose of this monitoring is to see how well the professional expertise you have hired (or are performing yourself) is doing.

You do not need to make your own calculations to measure the performance of your mutual fund holdings; there are many that provide information on mutual fund performance, and that also provide appropriate benchmarks for comparison.

If you are investing in stocks or bonds on your own, measure your individual stock or bond portfolio performance against an appropriate index or similarly managed mutual fund as a test of your own investment decision-making ability. To determine the performance of your own stock portfolio, use the approximation formula, and make sure that the benchmarks you are comparing performance against cover the same time periods.

If you have an investment adviser selecting individual stocks for you, measure him against an index and mutual fund averages composed of stocks similar to those he is managing. The adviser should be able to provide you with the return on your portfolio; make sure it covers a standard time period, so it can be measured against an index or average that covers the same time period.

What do you do with this performance information? For mutual funds and advisers, if the performance figures are good relative to the benchmarks--no problem. If the figures are unsatisfactory, you have to decide if you want to sell the fund (or drop the adviser) and look elsewhere.

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Measuring Risk in a Bond Portfolio

What does bond duration indicate?

The effective duration for a bond portfolio is the best indicator of interest-rate risk. Duration is a sophisticated measure of a bond's "average" life, considering its time to maturity, stream of interest payments, and price. It's essentially a weighted average time to recovery of all payments to the bondholder. For instance, the duration of a 20-year zero-coupon bond is its time to maturity—20 years—since all payments are received at that time; the duration of a 20-year, 10% coupon bond would be less than 20 years, since income payments are received prior to maturity. The duration of a bond mutual fund is found by averaging the durations of its bonds.

The shorter the duration, the less risky the bond.

Up-to-date duration information can be obtained from Morningstar.com and other Web sites that cover mutual funds or by contacting the fund company. Typical maturity-group duration ranges are one to three years for short-term funds, four to six years for intermediate-term and seven to 10 years for long-term portfolios. Conversely, money funds have readings near zero. The higher the number, the more net asset value fluctuates in response to interest rate changes. For example, if interest rates increase by one percentage point, a long-term fund with a duration of 12 could be expected to fall about 12% in value. The longest durations are found among the long-term target maturity bond funds.

Be aware that duration gauges only the interest-rate risk of a bond fund, not its credit risk, currency risk, or any other potential perils.

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