Five-Step Reallocation

Since there’s been an appreciable run-up in stocks over the recent past, now may be a good time to reallocate your investment allocations in your retirement plans and other accounts. You’ve probably heard of reallocation before – but what does it really mean?

Reallocating is the process of changing your current mix of investments to a different mix. It could be that you’ve changed your risk assessment and wish to have more stock and fewer bonds, vice versa, or your investments have grown in some categories from your original allocation and you need to get the mix back to where you started.

At any rate, reallocation is a relatively simple operation, and research tells us that it is important to reallocate regularly, such as on an annual basis. Below are five steps that you can use for a simple reallocation in your accounts.

Reallocation in Five Steps

1) Reallocating, sometimes referred to as “rebalancing”, requires taking a look at your overall investment portfolio. You need to bring together all of your different investment and savings account statements and review the allocation, comparing to your goal allocation. You might put this information on a spreadsheet on your computer, or just on a sheet of notebook paper.

For some people, this could take quite a while – if you have several bank accounts, retirement plans, maybe a brokerage account or two, and then some savings bonds, for example, it can take quite a while to pull all of this together. This may be one reason why folks don’t bother with reallocation. Believe me, it’s worth every minute of effort! Without reallocation, some components of your investment assets can become too large of a part of your investments, changing the risk structure of the portfolio.

So anyway, go ahead and pull all of the account information together.

2) Once you’ve done this, break down your overall retirement portfolio into three categories – cash, bonds, and stocks. For our purposes, you should consider bond mutual funds, individual bonds, and preferred stocks in the “bonds” category. Likewise, consider individual stocks and stock mutual funds in the “stocks” category. Real estate or other non-stock and non-bond investments should be considered as a fourth category, if you have any those.

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3) Now that you have the categories split up, add up each category of items separately, and divide that amount by the overall total. This will give you your current ratio.

4) The next step is a little more difficult. It requires you to think about what kind of “split” you’d like for your investments. For each individual, this split will be a little different. There are rules of thumb that you could use, but in the end, this split is a personal decision for you to make. Generally speaking the more that you have allocated to stocks, the more risky your portfolio is. So, a 60% stock/40% bond portfolio is more risky than a 50% stock/50% bond portfolio, generally speaking.

Some of the factors that you need to consider are your age, the number of years until retirement, your health, and the same factors for your spouse. In addition, consider your children’s education expenses, as these often cut in to the amounts available for your retirement.

Bear in mind that this split ratio will be a number that will change as time passes. For example, a person at age 25 may have a ratio of 90% stocks, 5% real estate, and 5% bonds. When this person reaches age 40, they might wish to have a lower-risk exposure, so they have changed their ratio to 70% stocks, 20% real estate, and 10% bonds. As this example individual nears retirement age, say around age 55, the ratio might adjust to 50% stocks, 20% real estate, and 30% bonds. (Note: these ratios are only for example and are not a recommendation. As stated earlier, each individual should determine the appropriate ratio for his or her own personal situation.)

A cash allocation is for those funds that you have a short-term need for. You might have college expenses to be paid from this fund, or perhaps you’re in retirement and need to money for living expenses. This money that is earmarked for use within say, five years, should not be exposed to the stock and bond market risk like your other long-term funds.

5) Once you’ve determined the ratio that works best for you, compare it to the real ratio that we calculated in step 3 above. All you have left to finish your re-allocation is to adjust your current holdings to match the ideal ratio that you’ve come up with for yourself.

Most retirement plan websites have a facility or toolset that allows you to do this re-allocation quite simply. If that’s not the case for your plan, simply determine which of your holdings that you need to buy and/or sell in order to make your allocation match the ratio that you’ve decided upon for yourself.

Note: If you have a mix of tax-deferred accounts and taxable (non-IRA accounts), you’ll want to be careful if you’re selling any positions in the taxable accounts as this can generate capital gains taxation depending upon your circumstances. This can be a nasty surprise come tax time if you’re not careful about it. Try to offset capital gains with capital losses in other holdings or accounts, or perform any sales of appreciated holdings within your tax-deferred accounts alone.

And you’re done! That was actually pretty painless, wasn’t it? This process will be much easier next time around (it should be done once a year, by the way) since you’ve already gone through it once. You’re on your way to financial independence, believe it or not!

If you’re finding this a little more complicated than you feel you can work out on your own, hire a financial advisor to assist you with the task. A fee-only financial advisor will assist you with this kind of task without trying to sell you investments. If you need some assistance in reallocating your investment account, especially if it’s your employer-sponsored retirement account, a fee-only advisor is your best bet.