Over time, the makeup of your portfolio changes as various sectors and stocks perform better or worse than the market. Your original well-planned portfolio allocation evolves to one where the best performing stocks or ETFs become a more heavily-weighted part of your portfolio. Then the stocks that have underperformed make up less of the total allocation of your portfolio. This is a very unappealing - and unhealthy - shape for a portfolio to be in and it signals that it's time to make some adjustments.

Get On the Scale
As time passes, it will become necessary for investors to re-examine their portfolio's allocation. Being overweight in some sectors may not be the best strategy going forward.
Stocks do not increase in value at the same rate. One asset category might appreciate more, causing an imbalance in your original allocation. In a 2000 study by Ibbotson and Kaplan, asset allocation was found to explain 93.6% of the variability of an asset's performance. Placing your assets in the right sector leads to overweighting that sector in your portfolio.

Over time, one sector will become the leader and another will lag. For example, during the height of the dotcom boom, technology returned 66.69%, while consumer staples lost 14.49%. In this case, your portfolio would have been overweight in the technology sector. In 2000, as the dotcom boom ended, consumer staples delivered a 26.04% return and technology lost 42.04%. If you adjusted the weight of technology and increased the weight of consumer staples, your portfolio would have thanked you. Adjusting your portfolio to reduce its overweight condition usually leads to success. (Learn more about the dotcom boom and bust in our Market Crashes Tutorial.)

So how can you tell if your portfolio is out of balance? The best place to begin is with your original assessment of the market that led you to form your current portfolio allocation. Some questions to ask are:

  • What has changed since your evaluation of the economy, the business cycle and the market? If your assessment has changed, then the weighting of your portfolio needs to change.
  • What is the current level of risk in your portfolio and how has it changed since your last assessment? If the risk has increased beyond your comfort level, it is time to adjust your allocation to bring your risk back to levels that are more normal. Often when a sector has risen dramatically, it increases the risk that you might lose much or all of what you have gained. Reducing this overweight condition by selling part of these securities can help to lower the risk in the portfolio.
  • Has the splendid performance of one or more stocks caused your portfolio to be less diversified, increasing its dependence on the performance of a few stocks? Diversification is a way to spread the risk across asset classes. As your portfolio over weighs toward one or a few stocks, your first-rate diversification has fallen off. (Find out how to find the right balance of diversification in Introduction To Diversification.)

    If answering any of these questions leads you to conclude your portfolio is overweight, it is time to reallocate by selling some of the shares of the securities that have performed well and putting that money to work in stocks or ETFs that have the best potential to outperform in the future.

    When to Make an Adjustment
    An overweight portfolio requires you to address underperforming stocks or ETFs as well as those that are your best performers. Stocks and ETFs do not grow at the same rate. One asset category might appreciate more causing an imbalance from your original allocation.

    When you make an adjustment, recognize that you will be dealing with underperforming stocks or ETFs as well as your best performing stocks or ETFs.

    For your underperforming stocks or ETFs, the following are some of the questions you should ask:

    • Are there problems with the company missing its earnings or revenue expectations?
    • Are there changes in management that raise concern?
    • Is the sector likely to continue to perform poorly over the next year?

    For your better performing stocks or ETFs, here are some of the questions you should ask:

    • Has the stock or ETF performed as expected?
    • Has the growth in revenues and earnings slowed or are the prospects for growth still in place?
    • How does the stock compare to its peers in terms of growth in revenues, margin, free cash flow and profit? (For more information on free cash flow, take a look at Free Cash Flow: Free, But Not Always Easy.)
    • Will the sector continue to outperform over the next year or is another sector about to take over? Buying in a bad year can lead to better performance in the next year. Selling after a good year captures profit should the sector have a bad year. It is a good strategy to capture some of your profits by selling your best performing shares.

    Most successful long-term investors review their portfolios on a regular basis. While you do not have to make changes every quarter, it is a good idea to reassess your original assumptions and analysis. Moreover, evaluate the risk of a reversal in the course of the market. You goal is to avoid incurring unexpected losses and confirm your current allocation reflects your view of the market.

    When to Stay the Course
    So far, we have discussed when to make adjustments in your portfolio as the weighting of the stocks or ETFs changes. However, sometimes it is best to stay the course.

    During your assessment of your best performing stocks or ETFs, you continue to believe they represent the best opportunities going forward. Often the underlying trend lasts for several years. In this case, should the trend continue, you and your portfolio will continue to benefit from the current overweighting.

    Maybe your portfolio is weighted to sectors, funds or stocks that have underperformed. In this case, you might be properly positioned for a rebound. After all, you could have been early. In this case, it makes sense to stay the course or even add to your underperforming segments.

    The tax man always has a say on when you can make changes in your portfolio. Capital gains on stocks or funds held for one year or less receive regular income tax treatment, whereas, securities held for more than one year receive more favorable tax treatment. While you should not make a decision to hold or sell a security only for tax reasons, it is one of the factors to consider. (Find out more about how your gains are taxed in Tax Effects On Capital Gains.)

    The Bottom Line
    A portfolio that is overweight in a sector, fund or stock should cause you to assess whether you should rebalance your portfolio. Simple allocation steps can help you to decide if you should rebalance or stay the course. Being proactive in your assessment will help to keep your portfolio properly aligned with the market, and is a lot better than sitting back and hoping everything will work out.

    For additional related information, check out Looking Deeper Into Capital Allocation and Shifting Focus To Sector Allocation.