You Know You Should Re-Balance, so Don’t Wait Till There’s an Emergency

Remember that promise you made to yourself earlier this year? You know the one. It was August. The global economy was teetering. . Russia was defaulting. And the bottom was falling out of the U.S. stock market.

You said that if things settled down and if the bull market returned, you’d do a better job “re-balancing” your portfolio.

In other words, you promised yourself that you wouldn’t put your investments on autopilot. (If you didn’t, the thought should have at least crossed your mind.) You’d adjust your portfolio routinely to ensure that your stock, bond and cash holdings--along with the specific types of those assets you held--were appropriately proportioned to meet your financial goals, but also to let you sleep well at night.

Yet four months later, many of us have forgotten this promise--or at least failed to make good on it. That, according to reports from financial planners and mutual fund companies, including giants Fidelity Investments and Vanguard Group.

Which is unfortunate. Because when investors fail to re-balance routinely--for instance at the end of every year--a disproportionate amount of their holdings ends up in stocks.

(If you don’t understand how this happens, imagine you held 50% of your investments in stocks and 50% in bonds at the beginning of this year. Stocks tend to appreciate faster than bonds. So, assuming your stock funds grew 11%, while your bond funds gained 7%, your portfolio would be 51% stocks, 49% bonds by the end of the year. Of course, if most of your stock investments were in emerging-markets funds this year, you might find yourself in the opposite situation.)

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Obviously, too much exposure to stocks isn’t that big a problem for young investors, who have a long time horizon, meaning they can--and should--take greater risks. But if you’re an older investor and you allow the proportion of your stock holdings to become too great, you could end up with a riskier portfolio than you can tolerate. If that’s the case, you may find yourself, in the next market plunge, rushing to re-balance just as stocks are nearing their lows.

Which is always a terrible idea, notes Michael Chasnoff, president of Advanced Capital Strategies in Cincinnati, because that means you may end up selling those shares just as the market is taking them down.

Also, by failing to re-balance your portfolio routinely, you may have to take a drastic step in order to bring your mix of stocks and bonds back into line.

For instance, you may have to sell shares of a mutual fund you like.

Many of us forget, but there are other, more subtle ways to re-balance a portfolio than simply buying, selling or holding a fund.

For instance:

* If you want to re-balance holdings in a tax-deferred 401(k) account . . . you can tweak allocations of future contributions.

Your 401(k) money is really divided into two piles: There’s the money you’ve already contributed. Then there’s the money that you will contribute in the future, through automatic payroll deductions. There’s no rule that says you have to allocate the second pile as you did the first.

So, say you’ve amassed $25,000 in your 401(k), and it’s split into 75% stocks and 25% bonds. Your preference, however, is to allocate your investments two-thirds into stocks and one-third in bonds. One way is to transfer some money out of your current stock fund holdings into a bond fund within your 401(k).

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But what if you like all of your stock fund holdings in that 401(k)? What if you own ProFunds Ultra OTC, which is up 145% year to date, and you don’t want to give it up? Another option--and a less painful one--is simply to change how new money is allocated.

In this case, all you’d have to do is tell your 401(k) administrator to put perhaps 40% of new money into stocks and 60% into bonds, at least until your overall portfolio comes back into line.

Jack Brod, a principal with Vanguard’s personal advisory services unit, notes that 401(k) investors should always consider this option first, thereby avoiding unnecessary sales.

* If you want to re-balance holdings in a taxable account . . . consider not reinvesting dividends or capital gains distributions.

“This is an excellent alternative,” notes certified financial planner Neta Gagen of Garden Grove.

Sure, it’s politically correct, in this day and age of personal finance, to automatically reinvest dividends and distributions, since that helps compound gains. But if you’ve discovered that your stock holdings are disproportionately weighted toward, say, large-capitalization U.S. stocks (given their tremendous run in recent years), you might want to take income and gains thrown off by that fund and put them into a small-cap fund.

Or a foreign fund. Or even a money market fund, while you study your options.

“By having distributions from all your funds, but particularly those from the large-cap funds going into cash, rather than reinvesting, you can move this money into your small-cap funds and re-balance your portfolio,” suggests Dan Wiener, editor of the Independent Adviser for Vanguard Investors newsletter.

Sheldon Jacobs, editor of the No-Load Fund Investor newsletter, notes that this strategy also works when “you aren’t happy with a fund’s current performance but don’t want to sell for tax reasons.”

The good news is that many fund companies will allow you to invest dividends from one of their funds into another, Jacobs notes. The bad news: If you don’t re-balance routinely, taking these “half-steps,” as Jacobs calls them, may not be enough to properly re-balance your holdings.

Which reinforces the importance of at least reassessing, if not re-balancing, your portfolio once a year.

Suggests Raymond Russolillo, director of personal financial services for PricewaterhouseCoopers in New York: “It’s better to do things gradually than to do things dramatically.” And it’s better to be in a position to do things gradually.

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Times staff writer Paul J. Lim can be reached by e-mail at paul.lim@latimes.com.