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November 1, 2014

Time For A Portfolio Rebalance

I rebalanced my portfolio, or more specifically my 403(b) retirement savings account, this week. The change was made after I conducted my semiannual review. The changes offer some insight into how various asset classes have performed and how I personally manage my portfolio allocations.
Our 403(b) plan, which is the equivalent of a 401(k) plan, is operated through Vanguard. In it, I hold five funds: Vanguard 500 Index Fund (VFINX), Vanguard Small-Cap Value Index Fund (VISVX), Vanguard REIT Index Fund (VGSIX), Vanguard FTSE All-World ex-U.S. Small-Cap Index Fund (VFSVX) and the Vanguard Intermediate-Term Investment-Grade Fund (VFICX). The 500 index fund gives me access to what is arguably the most frequently used benchmark. The domestic small-cap value fund takes advantage of two factors shown to lead to higher returns: value and small company size. The FTSE small-cap fund gives me diversification via international small-cap stocks. Real estate investment trusts (REITs) have had similar long-term returns as small-cap stocks, tend to offer diversification benefits over longer periods of time and are one of the few asset classes to have a higher correlation to inflation. The bond fund provides diversification, buffers the portfolio against volatility and serves as a counter-weight I can rebalance into during bull markets for stocks and out of during bear markets for stocks. (I gave a longer explanation of my allocation, as well as the corresponding Admiral Share mutual fund and exchange-traded fund (ETF) tickers, last year. Vanguard will not allow us to hold the less expensive Admiral Share class funds in our accounts regardless of how much we have saved.)

I use an equal-weighting methodology with a target allocation of 20% for each fund. I check my portfolio twice a year—at the start of May and at the end of October—to see if it needs to be rebalanced. These two periods coincide with the change between the worst six months for stocks (May through October) and the best six months for stocks (November through April). If any allocations are off-target by more than five percentage points, I rebalance.
When I checked the account on Sunday, two funds triggered the rebalancing. The REIT fund was at 105.5% of the average position size, or 5.5 percentage points more than the targeted allocation. This is not surprising given the fund’s performance. REITs have been performing exceptionally well; Vanguard’s REIT fund is up 15.1% over the past 12 months (through October 29, 2014), according to Morningstar. The international small-cap fund was at 91.4% of my average position size, or 8.6 percentage points below its targeted allocation. International small caps have lagged, overall down 1.2% over the last 12 months. The S&P 500 fund nearly set off a rebalancing alert as well, with a weighting of 104.9% of my average position size. The fund is up 14.0% over the past 12 months.
My rebalancing process involved moving dollars out of the REIT fund and the S&P 500 fund to lower their weightings to 100% of the average position size (a portfolio weighting of 20% in each fund). I then boosted the weighting of the international small-cap fund to 100% of the average position size. The remaining balance was allocated to the intermediate-term bond fund, which was at 97.8% of the average portfolio position. The fund is up 5.78% year-to-date thanks to the drop in interest rates. Had the other funds been closer to their target allocations, I would not have adjusted the bond fund’s allocation.
The only fund I did not touch was the value small-cap fund. Though up 10.3% over the past 12 months, the fund has lagged much of this year. This resulted in an allocation of 100.4% of the average position size. Investing is messy, and there is no reason to adjust an allocation that is a mere 0.4 percentage points off of its target.
Keep in mind that the balances in my account are impacted by the timing of purchases. Because I contribute to the account through automatic payroll deductions, the dates at which new dollars are added to each fund alter both my return and the allocations. (For those of you who are curious, Vanguard says my portfolio is up 10.4% for the period of October 1, 2013, through October 27, 2014.) If no money had been added or if withdrawals had been made, the allocation percentages may have been different for each fund.
Most importantly, realize that these changes are not a market call on my part. Rather, they are a result of me adhering to a preset investment policy intentionally designed to take emotions out of my investing decisions. Staying disciplined is the most the important part of my investing process.
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here)

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