Question:

I am trying to manage the risk in my portfolio following your suggestions. I chose a 60 percent equity portfolio, since I think that is about right for me. But as the value of my equity funds has fallen, the equity/fixed-income ratio and asset class percentages have become quite distorted from my original plan.

Instead of 60/40, I’ve now got a 45/55 portfolio. Since equity prices have fallen so much, I have decided to move some of my fixed-income holdings into equity funds. (I have also rebalanced the asset classes within my equities.) If the market keeps dropping, I’m planning to convert another 5 percent to 10 percent of my fixed-income funds into equities.

This is very painful; it feels as if I am putting more of my money at risk. But I no longer contribute to my IRA and this rebalancing process is the only other way I know to “buy low.” I have faith that these moves will eventually pay off when the market begins recovering. I will have more equity shares, bought at a lower average cost, and that should enable me to recover faster.

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ERIC JONSON:

First, let me congratulate you on your actions. You are absolutely doing the right thing, and I think you understand the ramifications.

You indicate that you have determined that 60 percent in equities is an appropriate allocation that is likely to meet your investment goals and keep you within your risk tolerance. This is a key part of building a successful long-term portfolio. You have also taken the second crucial step by diversifying your investments into many asset classes. This spreads your risk and enhances your potential returns.

Your third step, rebalancing, is the necessary process to keep your portfolio working properly. Rebalancing may or may not bring you higher returns; there is no way to know. But there is no doubt that it will keep your level of risk under control.
 
You are right that rebalancing can be painful. Many people resist this process because it seems to require “punishing” their better-performing assets and “rewarding” the laggards in their portfolios. Reducing portfolio management to emotional equations like that is essentially shooting yourself in the foot. Some investors don’t rebalance because they can’t bring themselves to get off the roller coaster when an asset class is going up, up, up – perhaps forgetting that it’s a roller coaster.

Over the past few years when equities were performing very well, rebalancing meant selling pieces of "hot" asset classes (such as emerging markets) and buying slower growing investments such as bond funds. This wasn’t easy, but it preserved some gains from equity funds and pumped those gains into fixed-income funds, which have been doing relatively well in the past year.

Now it’s time, as your percentage figures illustrate dramatically, to do the opposite and move money from fixed-income into equities so you can get your portfolio back to your original allocation.

The moves you are contemplating might not be the right ones for everyone. As you point out, you will be adding risk to your portfolio. For many investors, that is simply too uncomfortable right now. We advocate rebalancing once a year, not more often. And in such unsettled times as we are seeing now, investors may want to discuss this with their advisers before they act.
 
For you, the benefits of rebalancing now are: First, you are putting yourself into position to more fully participate in the equity market when it rebounds; second, you are taking the emotion out of the investing process; and third, this is a natural sell high / buy low process that will enhance your returns over time.
 
You bring up another important point, that keeping your portfolio in balance is much easier for people who are periodically adding money to their investments, as they may not have to sell profitable funds. But after the big drops in the equity market over the past year, most investors can’t get the job done just with new cash.

In the short term, increasing the level of risk in your portfolio by selling fixed-income funds and buying equity funds is likely to be uncomfortable. But in the long run, it is the right thing to do. I hope you will keep the faith and keep rebalancing once a year no matter what the market does.

Eric Jonson is a financial adviser for Merriman