401(K) Follow-up: Re-Balancing Your Portfolio by Analyzing Risk Tolerance

In A Guide to Choosing 401(k) Mutual Funds and Asset Allocation, I outlined a strategy to choose from the various mutual funds available in your 401(k) account and allocating an appropriate percentage of your contributions between each, depending on whether you are a conservative or aggressive investor. However, that's really just the first step. Once you choose your allocation, you have to periodically follow up to make sure your plan is working. This article will discuss the follow-up that I recommend.

In all my articles, I like to make the disclaimer that I am not a professional, by any stretch of the imagination. I'm a guy who has been fascinated by stocks and everything finance and opened my first IRA at the age of 17. I like to share what I have picked up along the way, but for professional advice, you should seek just that-a professional!

Once you have picked your asset allocation, unfortunately you can't sit back and close your eyes until retirement. You have to follow-up periodically to see if anything has changed. Has your allocation strayed from your target mix? Has your risk tolerance changed? I recommend that you perform this financial checkup annually.

The first thing you examine is how your current allocation compares to your target allocation. If you want to target 80% stocks and 20% bonds, but stocks have risen while bonds have not, your current allocation may be around 95% stocks and 5% bonds. Based on this, you should convert some of your stock holdings to bond holdings to get closer to your targeted 80/20 mix.

But, before you initiate the transaction, you need to re-examine your risk tolerance. Hopefully, your philosophy hasn't materially changed by some market condition. However, the degree of risk of a particular investment most definitely changes as the market fluctuates. We all know that the stock market swings over time-often times wildly. At times, the market goes up more than the underlying economic indicators would reasonably justify. This is what led to the infamous bubble in 2000. People kept buying, which drove stocks up which made people buy more, driving stocks even higher. Even when some still, small, voice told us that it was too good to be true, the market continued upward. Finally, it all exploded into a mass of dot.com carnage. My point is that, if stocks rise faster than the underlying economic indicators, they will most likely fall back. This means that the risk/reward balance is tilted a little more toward risk, and you should adjust your allocation to accommodate this.

A real life example for me is from during that time. My financial checkup in 2000 told me things weren't quite right. When snow-shovel.com went through the roof on the South American stock exchange, and flip-flops.com doubled on the Greenland Exchange, I was cautious. Despite all the euphoria, I moved a lot of my stock holdings in early 2000 to bonds. Sure enough, the market crashed. Three years later, after everyone was convinced the stock market would never recover, my checkup told me to move more money back into stocks and I was able to increase my stock holdings close to the beginning of the current bull market.

The point is, what goes up usually comes back down. I am by no means encouraging you to start day-trading with your 401(k). Rather, you can make subtle changes to your asset allocation based on your risk tolerance when the risk of investing in the stock market increases as the market rises, or decreases as it falls.

If the market has had a record year, maybe you should go from an 80% stock 20% bond portfolio to a 75% stock and 25% bond portfolio. This subtle change will help you cash in some of your profits and minimize risk associated with a potentially over-inflated market. When it swings the other direction, move some money back into stocks.

This does sound a lot like market timing, but it isn't. We're not making rash decisions in hopes that the market will do something. We are making subtle changes because the market has outrun the economic indicators and might be ready for a reversal. Such subtle changes ensure you. This technique has worked well for me multiple times: the 2000 bear market, 2003 bull market and the 2008 correction. Whatever your do, consider your move carefully and be sure you fully understand your plan's redemption/exchange policies.