Rebalancing investments? Consider time horizons

Now that the new year has arrived, it’s time to think about rebalancing your investment portfolio.

Correction: That’s portfolios – plural.

Most of us don’t think about this much, but it’s common to have two, three or four portfolios – perhaps more.

That’s because in addition to saving for retirement, you may be saving for college for one or more children. And you may be setting money aside for a down payment on a home or vacation place, for a new car or to redo the kitchen.

Each goal has its own “time horizon” – the time until you’ll need the money. And you may be willing to take more risk with, say, funds for a nonessential vacation home than with your children’s education accounts.

At the same time, money for various goals may or may not be mingled in the same brokerage or mutual fund accounts.

Planning for future

So how do you sort it all out and pick the right mix of holdings to fit all these factors?

Obviously, the first step is to list each goal, how big the fund needs to be and when you expect to withdraw the money. Also note how much risk you are willing to take. Suppose the fund fell 50 percent short of your goal; could you live with that?

Next, keep in mind the basic rule of investing: Bigger returns almost always entail bigger short-term risks. But if you have lots of time, the short-term risks don’t matter as much.

This is why the chief investment for long-term goals is stocks, or mutual funds that hold stocks. In any given year you may lose money on stocks, but over periods of five or 10 years, or longer, an investment is likely to grow faster in stocks than in bonds or cash, which means bank savings or money-market accounts. Bonds and cash are safer, but not as generous.

Over long periods, you might expect stocks to provide average annual returns of 8 percent or 10 percent a year, while bonds might give 4 percent to 6 percent, cash just 2 or 3 percent.

For the next step, use an asset allocation calculator. There are lots of them on the Internet, but most are aimed at retirement and don’t adapt easily to other goals. So look at the one under the Tools tab at www.morningstar.com. It’s part of the premium service that costs $14.95 a month, but there is a free 14-day trial.

Use this separately with each goal, playing with the mix of cash, bonds and various types of stocks. The calculator will show the odds of reaching your goal. Look carefully at the projected investment return as well as the risk, expressed in losses you might suffer over any three-month period.

If you have specific accounts dedicated to certain goals, you can make adjustments to each account to meet the target asset allocation – moving money from bond funds to stock funds, for example.

Several goals, one account

The job is harder if money for various goals is mixed in one account. Suppose, for instance, that you use one mutual fund account to save for a child’s college costs in 10 years and your own retirement in 25 years.

You could withdraw the college money and put it into a separate account with a different asset allocation. But that might trigger an undesirable tax bill on profits earned to that point.

Instead, figure how much of the account is currently earmarked for each goal and apply the asset allocation to each, then figure a combined allocation.

Suppose there were $50,000 in the account, $40,000 for your retirement and $10,000 for college. And suppose you wanted 80 percent of your retirement investment in stocks but only 50 percent of the college fund in stocks, since college is coming sooner.

Then you’d want $32,000 of the retirement fund and $5,000 of the college fund in stocks.

For the entire account, $37,000 would be in stocks – 74 percent.

Reducing taxes

One final point: Minimize taxes.

Rebalancing a portfolio usually means selling one holding to buy something else, and that can trigger capital gains taxes if the sale is in a taxable account.

But there is no tax if the sale is from a 401(k), IRA or other tax-sheltered account.

If your retirement investments are divided between a 401(k) and an ordinary taxable account, think of them as one big account for asset allocation purposes.

Be sure to make any changes in the 401(k) to avoid taxes.

It doesn’t matter that its allocation does not match your target so long as the two accounts do when taken together.