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Financial Check Up

It’s time to check your portfolio distribution.

Temperatures are rising, kids are getting out of school, and the smell of grill smoke is in the air. It’s summer time! With the arrival of June, it’s time for a great many things, but one of them may surprise you: It’s time to check your portfolio distribution.

Is good news really good?

Solid market performance is usually seen as a boon for portfolios. The challenge is that not all assets grow at the same rate. Small cap stocks can grow much faster than corporate or government bonds. When one portion of a portfolio grows faster than others, you may find yourself at risk of what’s called “portfolio drift.”

When you first set up your portfolio, the two biggest considerations were timeline to retirement and tolerance for risk. Based on those two factors, advisors create an investment strategy to set portfolio target figures. Market performance, however, does not frequently accommodate such plans.

For many investors, this is no big deal. They let the market dictate the terms of their portfolio and take a very minimal role in sticking to an investment strategy. This is undisciplined investing, and it’s trouble.

Drifting away

The core risk with portfolio drift is over-exposure. Sectors that tend to grow much faster also stand to lose much faster. Sudden gains in volatile areas of the market may leave you over-exposed to more risk than you can tolerate.

Consider a portfolio of $10,000. Its manager has chosen a moderately aggressive split of 50% small cap and international equities, 40% blue chip and investment grade bonds and 10% in highly liquid securities. That distribution puts $5,000 in growth stocks, $4,000 in income stocks, and $1,000 in cash reserves. Having set the distribution, the manager leaves the portfolio largely unattended.

Years later, the portfolio has drifted considerably. The $5,000 in growth stocks has done very well and doubled. The income stocks have been steady and have increased to $5,000. The cash reserves remain the same at $1,000. Now, the portfolio is balanced much more aggressively. The growth segment is now 62% of the now $16,000 portfolio, while the income segment is about 30%. Cash reserves now constitute about 6% of the portfolio.

This drift leaves this particular portfolio vulnerable to changes in volatile growth markets. A decline in the growth sector would leave this portfolio depleted. Rebalancing it would help to ensure the investor was only exposed to a comfortable level of risk.

It’s not only gains that could threaten portfolio balance. A loss in the growth sector could leave this portfolio under-exposed to market rebounds. A decline in the value of growth stocks reduces the percentage of the portfolio invested in what are now cheaply priced segments. When those stock prices recover, the portfolio will be weaker, ultimately, because of a failure to rebalance.

How often?

Most experts advice rebalancing a portfolio twice a year at minimum. Otherwise, rebalance when the portfolio drifts away from targets. It’s possible to make yourself crazy by constantly checking the markets and making micro-adjustments to portfolios in an effort to keep them perfectly in balance, but that’s probably not necessary.

Think of maintaining a portfolio like maintaining any other appliance. It needs regular upkeep, just like tire rotation for a car. It also needs emergency maintenance, like replacing blown belts or gaskets. Portfolios need both of these, too.

A routine checkup to a portfolio should occur every 6 months. This may be nothing more than a check-up. If the portfolio is still in line with goals, no further action is needed. If the portfolio is just slightly off, say, by a percentage point or two, re-check in another month to see if the balance is any further out of whack. That’s why experts recommend picking a day in early January and another in early June to sit down annually with a calculator and examine your portfolio closely.

Portfolios also need emergency maintenance, but unlike a car, they don’t flash lights for it. One of the benefits of keeping a regularly scheduled portfolio checkup is that you can see drift coming and plan for it. If a portion of your portfolio is more than 5% off its target, your portfolio is in need of rebalancing. Liquidate assets in the overweight segment and use the proceeds to buy assets in the underweight ones.

If a large market event like a big IPO or huge drop in stock prices occurs, it’s best to check the portfolio for balance afterward. The same is true if your portfolio receives a sudden cash infusion, whether it’s proceeds from the sale of a house or an inheritance. Life circumstances can also mandate rebalancing. If early retirement becomes a realistic possibility for you, your portfolio as the retiree will need to shift to more secure, income-generating securities. Should a major financial setback occur, like unexpected property damage or a major medical expense, your retirement plans may need to be pushed back. This move would also require a revision of your portfolio guidelines and an attendant rebalancing.

More broadly, portfolio goals need periodic revision as well. The old standby rule was multiply your age by two to identify a percentage of your portfolio that should be in income securities as opposed to growth-oriented ones. This is a rough guideline, and it errs on the side of conservatism. Meeting with a financial advisor can help to find a ratio that is suitable for every stage of life and risk tolerance.

Portfolio maintenance can be a serious hassle, but it’s a requirement for anyone who takes their retirement savings seriously. Disciplined investing requires taking steps to ensure investments are where they need to be. This investment focus will help promote the growth of your portfolio and your continued prosperity.

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