06/17/96 A REBALANCING ACT TO PROTECT YOUR PORTFOLIO

A REBALANCING ACT TO PROTECT YOUR PORTFOLIO

If you started off last year with a carefully constructed asset-allocation plan for your mutual funds, you now may notice something is out of whack. Say you chose to apportion 70% of your fund portfolio to stocks and 30% to bonds. The huge runup in stock prices likely increased the equity component dramatically, thus raising your risk. Similarly, if bond prices rose, you would be susceptible to higher risk levels. Both scenarios can wreak havoc on your asset ratios.
So what time is it? It's portfolio rebalancing time. Periodically putting your investments back in order by shifting money among asset classes is a necessary chore for investors who devise an asset-allocation strategy--whether the market goes up or down. ``The primary purpose of rebalancing is to maintain a consistent risk profile,'' explains Steve Norwitz, vice-president of T. Rowe Price Associates.
It also provides a regular plan of action. ``Rebalancing helps the investor avoid counterproductive temptations in the market,'' says Jonathan Pond, a financial adviser who publishes Jonathan Pond's Quarterly Investment Review. For example, rather than be tempted to follow the crowd, buying popular stocks when prices are already high and selling the dogs everyone is dumping, having a plan of action ``forces you to buy stocks after prices have fallen and sell them after prices have risen.''
Although these are desirable results for any investor, rebalancing is significantly easier and usually more effective for nontaxable accounts such as individual retirement accounts, 401(k)s, and annuities than they are for taxable ones that might take a capital-gains hit. A general rule of thumb: Always rebalance for nontaxable accounts, and evaluate the tax consequences for regular, taxable funds.
SAFER GAIN. For tax-deferred accounts, shifting among asset classes may have the added benefit of improving overall performance. A 1995 T. Rowe Price study compares the 26-year results of an unbalanced tax-deferred portfolio with one that was rejiggered quarterly to maintain the original investment mix of 60% stocks, 30% bonds, and 10% cash. In the unbalanced portfolio, $10,000 invested at the end of 1969 grew to $150,109 by yearend 1995. Because the equity portion swelled to 74% of assets, debt holdings fell to 22%, and cash shrank to 4%, the investor's risk exposure was substantially increased. The balanced portfolio, by comparison, had a value of $154,035 at the end of the period. What's more, equity risk exposure was maintained at the 60% level.
The study shows that asset rebalancing helped protect against losses in stock-market downturns. For example, the steep drop in stock prices during the 1973-74 bear market reduced the equity allocation of the unbalanced account to 49%, while the rebalanced portfolio maintained its 60% position by buying stocks at bargain prices. Clearly, the rebalanced account was better positioned to take advantage of the market's subsequent upturn and keep up the gains after that. ``While the unbalanced portfolio was able to close the gap during the strong bull markets, its gains were not enough to overtake the rebalanced portfolio,'' says Peter Van Dyke, chairman of T. Rowe Price's asset-allocation committee. ``In effect, the rebalanced portfolio reduced an investor's loss during severe market downturns but over time provided a competitive return relative to a more aggressive portfolio.''
Rebalancing the taxable portion of your portfolio is considerably more complicated and time-consuming. ``In many instances, the potential adverse tax consequences outweigh the benefits,'' says Pond. That's because of the 28% capital- gains tax that will eat away at any mutual fund profits. In this case, it's best to reestablish your portfolio's original allocation by investing new money into the necessary categories rather than shifting existing assets. Another option might be to take the dividends from a fund that has overgrown its allocation target and direct them to your portfolio's lagging sectors.
If you do decide to unload fund shares in an appreciated taxable account, make sure you sell the ones that cost you the most to buy. The higher the cost basis, the lower the capital-gains tax. Some mutual fund companies offer a tax assessment on sales to help determine your gains or losses. There's also the possibility of a tax loss, in which case you could deduct up to $3,000 from your ordinary income in any one year. If the loss is more than $3,000, then you may carry it into forward years indefinitely.
When you're convinced of the importance of rebalancing, the question remains: How is it done? The method is surprisingly easy, Pond says. First, you will want to review all of your investment accounts, because you won't accomplish much if you're rebalancing only part of your portfolio. You can decide later whether or not to sell shares or use new money. Go over the target allocation you initially set and consider any changes in those percentages you may want to incorporate. Next, summarize by investment category your current portfolio balances and allocation percentages.
Then, calculate how much money you'll need to add or subtract from each fund to return to your target allocation. If it's a taxable fund, take out 28% of the addition or subtraction, which would represent the tax cost of rebalancing that portion of your account. If your portfolio has gotten tremendously out of whack, a 28% hit may not amount to much.
Add or subtract from each fund to bring that asset category back into balance. Before you undertake this task, you'll want to consider the timing. ``The vast majority of investors shouldn't do it more than once a year,'' says Jeff Kelley, senior editor of the Morningstar Mutual Funds newsletter. He also advises doing it the same time each year so that you're looking at the same trailing 12 months. One exception to the annual rule, suggests Pond, is to rebalance your nontaxable account if stock prices move 10% in one direction or if 30-year Treasury bond rates vary by 1%.
You may find that once you put a pencil to paper and do the math, your rebalancing efforts result in a wash. Say one large capitalization growth-stock fund outperforms another in a given year. It doesn't make sense to realign these two funds since they're very similar in style. ``So make sure when you make a change, it makes a difference, such as shifting assets between a foreign stock fund and a small company stock fund,'' says Doug Loudon, a managing director of Scudder, Stevens & Clark.
FAMILY AFFAIR. Also, make sure your rebalancing benefits aren't lost to transaction costs from broker fees. It's best to do the process through no-load funds or load fund families that allow no-cost shifts within the family. Even better are the automatic rebalancing services offered by some mutual fund companies, such as Stein Roe, Fidelity, and T. Rowe Price. Stein Roe's Counselor Preferred plan, for example, will create an asset-allocation strategy for the investor with a balance of $50,000 or more. The fund company will do a monthly review of the account, determine whether it's prudent to shift assets given the tax consequences, and then automatically take the most economical action. The service costs about half a percent of assets a year. Stein Roe's regular Counselor plan, which is free, will send a detailed asset-allocation report with recommendations, but it is up to the investor to make changes.
Naturally, it's easier to have someone else do your mutual-fund housecleaning. But regardless of who does it, the longer you wait, the messier the job gets.
EDITED BY AMY DUNKIN By Toddi Gutner