Has Your Portfolio Gotten Top Heavy?

With the Dow Jones industrial average shattering the 9000 mark recently, the stock portion of your mutual-fund portfolio has likely grown larger in relation to the other components. That's great news if you're just looking for the highest return. But if your goal is to maintain a certain balance among assets to limit the portfolio's risk, your allocations may need some serious review.

GOAL-TENDING. A good investment plan looks out over a number of years, and it has an objective. This might include your child's education, a downpayment on a house, or money for retirement. In each case, you select an asset allocation and specific funds to meet these goals.

In the best-case scenario, your asset mix stays in about the same proportion for the entire time the plan is in place. In the real world, though, this seldom occurs because funds grow at different rates. For example, over time, a stock fund's performance will normally be far greater than a money market's. If you have a portfolio that starts with an even split between stock and money funds, the stock funds will dominate. After five years of solid equity-market returns, it's entirely possible you'll wind up with almost 100% in stocks.

Is this really a bad thing? The answer depends on your objectives. If you started with the goal of maximizing your returns and have a high tolerance for risk, the equity fund's gain is pure gravy. However, if you have a shorter time frame or need to be very conservative, the growth in the equity portion can be a big problem. Says Boston-based certified financial planner Susan Graham: "Once a year, I will sit down with my clients and review their portfolios. If the allocations have changed and they aren't comfortable with the new mix, we will discuss a shift in assets." She adds that it's important to check allocations within an asset class, such as equities: "If you had planned to have an even mix between domestic large caps and small caps, and now that mix has changed, a rebalancing might be in order."

Let's assume your goal was conservative growth with income, your time horizon was more than 10 years, and you had $100,000 to invest. To achieve the goal, you set up an allocation in March, 1993, that was 50% stock funds and 50% money funds. Your 50-50 split was designed to be conservative, yet allow some participation in the equity markets. For your stock fund, you picked the popular large-cap Legg Mason Value Trust-Primary, and for the money fund, you chose the Vanguard Money Market Prime Portfolio (table).

It's now five years later, and the equity market has been on a roll. This has caused your Legg Mason stock fund to grow at an annualized pace of about 28% and 241.95% cumulatively. The money fund has chugged along slowly, averaging about 4.8% with a cumulative return of just 26.64%. You now look at your portfolio and see that something wonderful and awful has happened.

MORE VOLATILITY. The good thing is your $100,000 grew to $234,295. The bad is that the stock fund now makes up 73% of the portfolio, while the money fund has declined to just 27%. Even though you have lots more money, the portfolio may be far too aggressive for your taste. In addition, the volatility as measured by standard deviation has increased. At the start, the weighted average standard deviation was 7.24%; now, it's 10.56%. That means the portfolio's value will move up and down in much wider swings.

If you do nothing, the portfolio will probably continue to edge closer toward a 100% stock allocation. So is it still a conservative growth and income portfolio? It sure doesn't appear that way.

Of course, there's nothing wrong with a portfolio more than doubling in size in five years. But the risk and reward characteristics no longer match the original intent. To restore the 50-50 ratio, you need to transfer $53,827 into the money fund from the stock fund. Doing this will trigger capital-gains taxes. But at the end of the day, you'll feel a lot better about the portfolio mix.

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