As the end to 2013 quickly approaches, you’re probably starting to think about how to rebalance your portfolio.  Most individual investors don’t really think about asset allocation when crafting their basket of investible securities.  If you did structure your portfolio with certain objectives in mind, there is no doubt that your allocation now is different from what it was at the beginning of the year.  Market forces, for better or for worse, change the relative weight of assets in a given portfolio.  If equities perform well, you might find yourself too heavily weighted in this particular asset class, with insufficient downside protection or cash flow yield.  If stock prices go down, you might worry that you are no longer able to reach your financial goals in the timeframe you initially set.  

Assuming you created a portfolio with a strategic objective and allocation, have you developed a strategy for dealing with these changes?  You'll probably want to take a look at your individual investments to ascertain whether they still fit your investment philosophy, but you'll also want to think about your asset allocation and how any periodic adjustment of it would help you achieve your investing objectives.

Obviously, simply making no changes would be easiest.  On an emotional level, if you’re happy with your portfolio’s current return profile it may be difficult to make any significant changes.  We are all guilty of subscribing to a “if it ain’t broken, don’t fix it” mentality.  Of course, allowing the status quo to persist may affect how well your investments will continue to match your goals, especially during unexpected (and eventual) turns in the market.  At a minimum, you should periodically review the rational for your investment choices to ensure that they still hold.

Constant Weighting
It might feel counterintuitive, but selling the winners and buying the losers (or other investments in underrepresentitive sectors) can bring your asset allocation back to the original percentages you had initially set.  This ‘constant weighting’ of relative investment types ensures that your portfolio grows at a proportional rate, factoring in all asset classes represented in the portfolio. 

Let's consider a hypothetical example. If your equity allocation in a portfolio that originally represented 50% is now at 70%, rebalancing would involve selling some of the stock and using the proceeds to buy back enough of the other asset classes to bring the portfolio back to 50% in equities.   Similarly, if stocks now represent less of your portfolio than they should; to rebalance, you would invest in stocks until they once again reach an appropriate percentage of your portfolio.  Maintaining relative percentages not only reminds you to take profits when a given asset class is doing well, but it also keeps your portfolio in line with your original risk tolerance.

When should rebalancing take place? One common practice is to rebalance a portfolio whenever a particular investment represents significantly more than it’s intended share of the portfolio (we call this a ‘tolerance band’); say, 5% to 10% of the total portfolio.  One could also set a regular date for rebalancing,  say, tax time or year-end.

Forecast Weighting
You could also adjust the mix of investments to focus on companies and sectors that are expected to do well in the future.  This is obviously a more speculative approach, and one that more active individual investors attempt to employ.  I would not recommend this strategy as a sustainable practice for long-term portfolio growth.

A Hybrid Approach
You could also combine the above two strategies by maintaining a constantly weighted asset allocation with one portion of the portfolio. With another portion of the portfolio, you could try to take advantage of short-term opportunities, or test specific sectors that you believe might benefit from a more active investing approach.  By monitoring your portfolio, you can always return to your original allocation.

A Bottom Line Approach
Another plausible solution is to set a “bottom line” for your portfolio; that is, a minimum dollar amount that the portfolio cannot dip below.  If you wish to be active with your investments, you can do so--as long as your overall portfolio stays above your bottom line.  I do not advocate active management in this fashion, but with this strategy you could theoretically move the portfolio to very conservative allocation (more conservative securities or cash) to protect that baseline amount.   Keep in mind that many speculative investments are illiquid, which presents additional and significant problems when trying to exit losing positions.

Key Rules for Rebalancing:

1. Be aware of market conditions and how your investments might react to them.  Certain investments counteract the risk of others.  Plan your portfolio with ‘risk’ in mind and rebalance with the same objective.
2. Be disciplined with your strategy and stick to your rebalancing plan.  Do not deviate from it.  
3. Stay true to your investment philosophy and check to ensure that the nature of what you've invested in hasn't changed.  You may own a particular mutual fund that overexposes you to a particular sector or geography.  This kind of “style drift” happens, but as an investor you must remain aware of what you own and why you own it.

Don’t forget about taxes and transaction costs
Frequent rebalancing can trigger tax consequences and expensive transaction costs. Check on whether you’ve held particular securities for over a year. If not, you may want to consider whether the benefits of selling immediately will outweigh the higher tax rate you'll pay on short-term gains.  This doesn't affect qualified accounts such as 401(k)s or IRAs, which are tax deferred. 

I hope this information is helpful to you as you work to rebalance your investments for the year ahead.  Please do not hesitate to contact me should have any questions about this article or if you are interested in discussing specifics about your portfolio.  

Best regards,
Jason M. Gilbert, CPA/PFS, CFF
T: 516-665-1940
E: [email protected]

For those unfamiliar, these products aim to provide a low-maintaince and singular retirement plan option.  These funds, which are also referred to as life-cycle or age-baed funds, crossed the $500 billion threshold in 2013 as reported by Morningstar (Reference).  They are designed, through the rebalancing of its asset-allocation, to become more conservative as the target date (usually retirement) approaches.  The demand for these products appears to remain strong.  In fact, Casey Quirk (an asset management consulting firm), predicts that target-date funds will account for nearly half of all U.S. defined contribution plan assets by 2020 (Reference).

While these retirement plan options do indeed make long-term investing easy, I do caution my clients that these funds are anything but simple, and my not really serve the purpose to which they are intended.  Here's why:

1. They are exceptionally complex products.  Each target-date fund comes with its own set of fees, risks, and mix of assets.  Comparing funds against one another is cumbersome task that requires a full understanding of each differentiating factor.  Measuring performance between funds is even harder.  
2. They are typically too generic to meet your needs.  Because these funds do not account for risk tolerances, they typically do not reflect the optimal asset mix.  Because they lack flexibility, these funds tend to underperform more constructive and customized retirement portfolios crafted to meet your unique needs.
3. They are expensive.  With an average target-date fund expense ratio of 0.70 percent (Reference), investors should seriously consider return erosion, or the impact that fees have on returns.  As noted above, many of these funds will lag the long-term results that can be achieved with a more individualized portfolio.  The added fees of these funds widen the gap.

Most investors select these target-date funds through their employer-sponsored 401(k) plan without ever considering the points noted above.  Be sure to do your diligence and resist selecting a life-cycle fund just because it's easy.

If you need any help analyzing your options, feel free to contact me.

Best regards,

Jason M. Gilbert, CPA/PFS, CFF
T: 516-665-1940
E: [email protected]

As we approach year-end, we should take a moment to consider retirement planning.  I urge my self-employed readers to start a retirement plan if one is not already in place.  Depending on your current circumstance, a cash balance pension plan (type of defined benefit plan) or a SIMPLE IRA (type of tax deferred employer-provided plan) might be suitable for you.  I will discuss both of these (and other retirement vehicles) in future posts.  For this entry, however, I'd like to focus on two popular and available options for the self-employed; the SEP IRA and the solo 401(k).

The SEP IRA
A Simplified Employee Pension Individual Retirement Arrangement (otherwise known as the SEP IRA), is typically adopted by business owners who seek to provide retirement benefits for the business owners and their employees.  

• There are no significant administrative costs for a self-employed person with no employees.
• All employees must receive the same benefits under the SEP plan (assuming the business has employees)
• The account can be opened at most major custodians and it offers the same investment flexibility as a typical IRA
• You can contribute up until your tax filing date (this includes the extension filing deadline of 10/15)
• Your contributions is limited (for 2013) to 25% of your compensation, or $51,000
• All contributions are made from the business.

The Solo 401(k)
A Solo 401(k), which is also known as a Self Employed or Individual 401(k), is a retirement savings vehicle designed specifically for employers with no full-time employees other than the business owners and their respective spouses.  A key element of this particular type of plan is that it covers only the business owners and their spouses, thus not subjecting the 401(k) plan to complex ERISA (The Employee Retirement Income Security Act of 1974) rules.

• Contributions include both employee and employer deferral components
• Contribution limits (for 2013) are $51,000, or $56,500 to "catch-up" if you are 50 years of age (or older) at any point during 2013
• These retirement vehicles can be opened at most any major custodian
• These retirement vehicles limit participation to sole owners, business partners and their spouses

So how do you choose between the two options?

Consider cash flow

• When you use a SEP-IRA with your employees, you will need to contribute the same percentages for your employees as you defer for yourself. This becomes an expensive proposition.  I generally recommend this plan for the self-employed with no employees.

• SEP-IRA contributions are calculated as a percentage of compensation, so if this amount varies significantly year to year, so will your allowable contribution.  A Solo 401(k), by contrast, allows you to defer the lesser of $17,500 ($23,000 if you're 50 or over) or 100 percent of your 2013 income plus the profit sharing contribution.  This flexibility may provide a better option for those with variable income and cash surplus.

Consider timing

• Both plans allow for contributions up to the tax filing deadline (including extension deadlines if you have extended your tax return).  The Solo 401(k), however, must have been established during the calendar year in which you would like to participate.

Consider features

• Loans are available from Solo 401(k)s but not from SEP-IRAs

• You may be able to enable a Roth feature on a Solo 401(k) if you plan documentation allows for it.  This is not currently possible with a SEP-IRA

• Both plans can be established at most custodians, and most custodians have a prototype plan document that can be used if you do not have your own.

Best regards,

Jason M. Gilbert, CPA/PFS, CFF
T: 516-665-1940
E: [email protected]