The Portfolio Rebalancing Act

Question of the week:At one point, my portfolio had exactly the right asset allocation. But now, it's totally out of whack. What should I be doing to get it back where I want it? --Joseph J.

Dear Joseph,

Because different parts of the stock market almost never go up or down at the same rate, every portfolio tends to get out of balance over time. But the large swings in the market over the last several years have really pushed portfolios around. What you need is a good rebalancing.

How to accomplish this? We recently asked members of the Armchair Millionaire community about how they do it and heard plenty of details. Here is one such comment:

"I rebalance on the final trading day of the year. I simply move my money (all mutual funds) back to the target allocations. My allocation is 40 percent S&P index fund, 20 percent small cap, 20 percent international and 20 percent U.S. government bonds." --Robbie

The idea behind portfolio rebalancing is simple: You sell a portion of your investments that have done well and buy more of those that have failed to keep pace. By shifting assets from one class to another, you restore your original asset allocation--the mix of investments that is best for your goals, risk tolerance and time horizon.

Many people tend to shy away from rebalancing because it feels counterintuitive. It means selling some of your winners--those that have done the best--and buying more of your losers. But it actually is essential for keeping your portfolio in sync with what you want to achieve. And recent academic studies show that annual portfolio rebalancing will add up to one percent or more in returns over a market cycle of five to seven years. It also has been shown to lower overall risk.

My guide will get you started on this all-important investment management technique.

The Armchair Millionaire Guide to Rebalancing Your Portfolio

• Set guidelines. Choose a margin of deviation for your portfolio that you can live with. For example, I aim to keep one-third of my own portfolio in large cap stocks, one-third small cap stocks and one-third international stocks. Whenever any one portion climbs above 40 percent, I know it's time to rebalance.
• Never act on impulse. Part of the benefit of being a long-term investor is not having to watch the markets every day. To avoid over-reacting to short-term market movements, commit to looking at your balance once a year, preferably in January. If each asset class of your portfolio is within your margin of deviation, leave it. If one class deviates too much, however, go ahead and rebalance.
• Consider adding money. Many people sell part of their over-performing investments in order to free up cash to buy more of the underperforming investments. There's another way, although it involves more active involvement with your trading. You can re-direct new cash purchases towards the asset that's underperforming, both buying on the cheap and re-balancing your portfolio. Then, put any automatic investment plan back on auto-pilot once you're back on track. The best advantage of this? When you avoid selling, you also avoid paying capital gains tax.
• Adjust your allocation as needed. You initially set your asset allocation because you had certain goals that you wanted to reach in a certain amount of time. As your financial goals change along with your time-horizon, re-consider your allocation and your portfolio's overall risk exposure as part of your regular rebalancing.

THE BOTTOM LINE: A smart portfolio is made up of investments that don't all move the same way at the same time. But sometimes this will lead to a portfolio that's gotten too far away from your original blue-print. By occasionally rebalancing your portfolio, you'll ensure that you stick to your original plans and have the kind of discipline that leads to long-term success.

Your Retirement Vs. Their College

Question of the week:We have a son in high school and want to be able to pay for his college education. However, our retirement accounts have been so beaten up that we also need to save as much as possible to shore them up. We don't think we can manage both, so where is it best to concentrate? --CPI

Dear CPI,

Given the sky-high cost of funding retirement and rocketing college tuition, your dilemma is shared by many. We asked the Armchair Millionaire community about whether retirement or college should be the priority for parents, and heard from both sides:

Take care of yourself. "During the pre-flight routine, we're always told that if oxygen is necessary, secure your mask first then help your children. Same goes for finances. Fund your retirement first, then help the kids." --Steven

Take care of the kids. "In a decision between your retirement or your kids' education, the kids' education wins, no questions asked. Children owe nothing to their parents, while parents owe the world to their children." --billmac

In my own opinion, when you can't do both, you should focus on your retirement. After all, there are no student loans, scholarships or work study programs available for your retirement years. And the last graduation present your kid would want is a pair of financially destitute parents.

But if you don't have a dime saved for your kid's college, don't despair. Even if your child doesn't qualify for financial aid, there are still many other strategies that will help bring college within reach. My guide tells some of the best.

The Armchair Millionaire Guide to Alternative College Funding

• Get a scholarship. Scholarships are generally reserved for students with special qualifications (like academic, athletic or artistic talent), who are interested in particular studies or who demonstrate financial need. They are not often awarded out of the blue, so it pays to seek them out. Scholarship reference books (found at your local library or from your child's high school counselor) are a good place to start. There are also a number of searchable online databases. Pass up on search services that charge a fee to locate scholarships--they won't turn up anything that you can't find yourself.

• Be of service. AmeriCorps, a government-run, domestic volunteer program, offers an education award of $4,725 to pay for college or re-pay student loans. Participants can also defer their student loans while serving. In addition, there are a number of government programs that forgive student loans in exchange for teaching, practicing medicine and other activities in economically disadvantaged areas. Since these are fairly specific, the best source of information may be your child's college financial aid office.

• Be in the service. For military-minded people, plenty of help is available:
  • Montgomery GI Bill. This program provides an educational benefit for up to 36 months of college for veterans who served on active duty.
  • Reserve Officer Training Corps (ROTC). This program offers generous scholarships that pay up to the full cost of college. However, ROTC scholarships are not available for every school or for every field of study and carry a substantial service obligation upon graduation.
  • Service academies. West Point, the Air Force Academy, Naval Academy and Coast Guard Academy all provide a free college education in exchange for a commitment to serve after graduation.

• Consider community colleges. These are the last great education values. A student can attend for two years while paying rock-bottom tuition, then go on to finish up a bachelor's degree at a four-year college.

THE BOTTOM LINE: With a bit of forethought and flexibility, both you and your child can be winners in the struggle between retirement and college.

Bear-Proof Your Portfolio

Question of the week:I've really gotten burned by the market over the last few years and I'm not very optimistic looking ahead. I'm tempted to cash out what's left and put it in CDs. What would you do if you were in my shoes? --Discouraged in SF

Dear Discouraged,

The great bear market of the last several years, coming so hard on the heels of the great bull market of the late '90s, has understandably left many investors gun shy. Despite this, I'd encourage you not to throw in the towel just yet.

We asked the Armchair Millionaire community for their perspectives on investing these days, and most comments revealed greater caution, but greater determination. Here are a couple:

"I have moved some money from more aggressive growth funds to more conservative funds, including value funds, and into bonds. But I still have a fair amount in the stock market and am continuing to invest via dollar cost averaging." --Karen C.

"If I had to do it over again, I would have included more conservative investments in my portfolio. I've continued to invest monthly (mostly growth and growth/income funds) over the last few years. My statements are depressing to look at, but I'm betting that my persistence will pay off." --Rondo

The theme in these comments? The bear market has taught these Armchair Millionaires to manage their risk more wisely.

You see, I believe a lot of the regret people feel right now comes from failing to appreciate the risk they were actually taking to get those terrific returns of the late '90s. So as you look ahead, it's important to know that you have a very important tool on hand--risk management--to help your portfolio ride out market swings. My checklist will help you get your bearings.

The Armchair Millionaire Checklist for Managing Risk

• Understand risk. Too often, investors think of "risk" as simply losing all their money. But it's more complex than that. If you own one particular stock, for instance, there are three major types of risk you face:
  • Company risk: the risk of that stock falling in price.
  • Industry risk: the risk of that stock's entire industry falling on hard times.
  • Market risk: the risk of the stock market as a whole dropping.
  If you own bonds (usually considered less risky than stocks), you still face risks:
  • Inflation risk: the risk of inflation eroding your returns over time.
  • Interest rate risk: the risk of changing interest rates affecting the price of your bonds.
  • Credit risk: the risk of the bond issuer defaulting.

• Know that nothing is risk-free. Even if you buy the "safest" investments of all--U.S. Treasuries--you still run very real risks. Your principal will be safe, but with low returns and the erosion of those returns by inflation, you risk not achieving your long-term goals at all.

• Know your risk tolerance. Risk tolerance is like pain tolerance. To make wise choices, you need a good idea of how much pain you can take if your investments drop in value. If your risk tolerance is low, you'll need to stick to more conservative investments that won't shift wildly in value. If you have a high risk tolerance, you can invest in more aggressive investments that will be more volatile.

• Diversify, diversity, diversify. Nothing works better to reduce risk than diversification. If you have a broadly diversified portfolio suited to your situation that includes domestic and international stocks, stocks with large, medium and small caps, and possibly a range of bonds, you'll buffer some of the market's day-to-day volatility. Mutual funds, because they own a number of stocks and/or bonds, are an easy way to diversify.

THE BOTTOM LINE: If you want the highest returns over time, accept the risk that goes along with those investments. If you can't take the heat, stick with lower-risk investments--but be prepared to have lower returns.

Saving a Buck at the Bank

Question of the week:Every time I open my monthly bank statement, I feel like I'm getting taken to the cleaners with all the extra fees and charges. What are your suggestions for avoiding these? --S.J.S.

Dear S.J.S.,

Given that bank fees are at an all-time high, it's no wonder you're feeling the pinch. According to a 2001 study by U.S. Public Interest Research Group, bank customers who don't meet minimum balance requirements pay an average of $228 a year for their checking account, including service fees, account fees, and that most annoying fee of all, ATM surcharges.

When we asked members of the Armchair Millionaire community for tips on cutting bank fees down to size, we received some creative responses. Here are a couple:

The urge to merge. "If you have a loan or credit card balance with your bank, combine the balance with your checking account. This could bump you up into a preferred checking account, which usually has most fees waived. Just be careful when the loans start getting paid down because this will lower your minimum balance." --Chris W.

Bank in your underwear. "Access your bank online and pay as many bills as possible online so that you don't have to replace checks as often." --Phil H.

The obvious first step would seem to be to keep your account balance above the minimum required to avoid most fees. However, by having to keep a particular stash in your checking account, you lose the opportunity to have that money somewhere else--such as in a CD or money market account--where it's likely to earn more than in your checking account. So what you save in fees you lose in interest.

This means that to really save you need to look beyond just keeping the minimum balance. Since banks have so many different fees, it's helpful to have your own bag of cost-cutting tricks. My checklist provides just that.

The Armchair Millionaire Checklist of Bank Fee Cost-Cutting Moves

• Consider a credit union. If you qualify for one, credit unions can save you a bundle in fees. One downside for avid ATM users, however: Credit unions can have smaller ATM networks than many banks, meaning you'll pay more often to use other banks' ATMs.

• Think small. The account fees at smaller, locally-owned community banks tend to be lower than at large regional or national banks. On average, they also require lower minimum balances to avoid fees.

• Look at a "no frills" account. These accounts, which charge a low, flat monthly fee, can be a good deal if you don't do a lot of check writing. They allow you to write up to a specified number of checks, but then charge for each check after that.

• Set up direct deposit. Many banks will waive or reduce checking fees when your paycheck is deposited directly into your account. Check with your employer. If you receive a Social Security check, you can also arrange for it to be direct deposited.

• Limit ATM charges. Plan ahead so that you don't need to drop by an ATM as often, or skip the ATM altogether by getting cash back when you shop with your debit card. When you do need an ATM, stick with ones owned by your bank.

• Get your checks printed elsewhere. There are many printing companies that provide checks for substantially less than what you pay by ordering checks through your bank.

• Shop around. There are still some deals out there, including free checking. Compare carefully, though, to make sure that the offers match what you really need.

THE BOTTOM LINE: No matter how much they get under our skin, bank fees are here to stay. With a bit of forethought, however, you can keep them under control.