Assessing your risk profile and rebalancing to it

One of the first steps to building an Asset Allocation Plan is to assess your risk tolerance. What kind of an investor are you? How much of a loss in your portfolio can you live with without spending sleepless nights? Do you have the "courage" to throw more money into the market during a downturn or will you sell in panic?

Be brutally honest with yourself and one certain way to test this is to live thru a downturn (we have had a few in the last 7 years, including the dot com bust in 2000). Think carefully about how it affected you - what was your reaction, what thoughts crossed your mind, did you reach your breaking point, did you break, did you sell in panic, did you buy like Braveheart?

If you can accurately guage your risk profile (believe me, its not easy) you can come up with a very important aspect of your asset allocation plan - the split between your equity holdings and fixed income, or in other words, your stock to bond ratio. This will form the basis of your financial plan and once you decide on it - stick to it no matter what.

For example, I like Larry Swedroe's (author and regular poster at the Vanguard Diehards forum at Morningstar) rule of thumb to determine stock bond allocation. Take your maximum acceptable loss percentage, multiply that by 2 and that should be your stock allocation. Meaning, if the maximum loss you can digest without panicking is 30%, then multiply by 2 = 60%. You should not hold more than 60% of your entire portfolio in equities.

Another rule of thumb is - invest your age in bonds and (100-age) in equities. If you are 35 years old, then hold 35% in fixed income and 65% in equities and adjust that as you get older.

Whatever be the allocation you choose, it is important to adhere to it - that is the only way you can be successful over the long term. And this leads us to the concept of rebalancing.

Lets say you came up with an allocation plan of 65% stock: 35% bonds based on your risk profile and are fully invested as such on Jan 1 2007. In Dec 2007, you look at your portfolio and you see that because of the continuing bull market in equities, your equity % of your total portfolio is now 70% and bonds make up only 30% of your portfolio. This would be a good time to rebalance - meaning make changes so as to bring your allocation BACK to 65% Stock : 35% bonds.

Now - how often should one rebalance, and how should one go about doing it

• My suggestion is to rebalance once a year or if your allocation is out of whack by greater than 5% - whichever comes first
• Rebalancing can be done with new money or old money. If you want to increase your bond allocation by 5% to bring your allocation back to a 65:35 split, add to your bond funds (buy 5% worth) with new money (salary savings etc). To use old money, sell 5% of your equity holdings and add that to your bond funds
• When rebalancing with old money, try to do the re-balancing inside of a 401k or IRA, so when you sell the equity it is not a taxable event, making your rebalance tax efficient

The act of rebalancing is an automatic way to "book profits" - now you dont need to ask - when should I take some off the table or is this a buying opportunity. If your overall stock allocation increases by more than 5% sell stock and buy bonds. If its the other way around, sell bonds and buy stock. If you allocation numbers have not changed significantly, do nothing. The selling/buying calls can be made based on your allocation numbers at any given time. Its a thing of beauty - cruise control baby!