Time to Rebalance

Just about every money manager recommends setting asset allocation targets and occasionally rebalancing to keep your portfolio close to those goals. The question is, when should you rebalance? I've seen recommendations that range from every month to once a year. My own approach is more flexible. When targets move well beyond my allocation goals, I consider rebalancing whenever it happens, regardless of timing. Last week, I recognized that surging foreign markets had pushed my international exposure well above my target. So I reduced my foreign exposure, moving the proceeds into some out-of-favor domestic stocks I've been eyeing.

This is the first time I've sold foreign holdings in the two years that I've been urging investors to increase their exposure. Many of the positions I've advocated in this column, including the India Fund (IFN); Brazil, South Korea and Japan exchange-traded funds; and broader emerging market and EAFE ETFs have soared over that period. During the past three years, the broad EAFE index has had an annualized return of more than 25%, and that's the worst performer of the group. The India Fund has quadrupled since I recommended it, not counting generous cash distributions. Brazil has doubled in a year.

In recent years, I was content to sit on these gains since I wanted my international allocation to rise. Rather than add to positions, I simply let them increase in value. But recently I realized that my new, expanded target had come and gone as the momentum on foreign exchanges seemed only to increase. Suddenly everyone was recommending greater allocations to foreign stocks, especially with the U.S. currency in retreat (which increases nondollar returns). Price/earnings ratios in many foreign markets now exceeded those in the far more stable U.S. With year-to-date gains in many markets already at 20% or more (over 40% annualized), I just didn't see how this could continue without stretching valuations to the breaking point.

So last week I sold the India Fund and a small-cap international mutual fund, both of which I've owned for years. Both sold off sharply later in the week, but even had I waited, I was looking at significant gains. I didn't eliminate my foreign holdings by any means. I kept my EAFE, emerging market, and Japan ETFs.

With the proceeds, I bought some stocks I've recommended in recent months, starting with BJ Services (BJS), an oil-services company I mentioned a few weeks ago. This is the first purchase I've made in the oil sector since I began paring my energy holdings as oil prices soared to new highs. The energy sector was hard-hit last week, with BJ dropping more than 10%. It's 20% off its 52-week high, even though oil remains close to $70 a barrel. This strikes me as a good opportunity to begin gradually increasing my energy holdings.

I also used the proceeds to add to holdings in eBay (EBAY), Yahoo (YHOO) and FLIR Systems (FLIR), all stocks I've previously recommended. I'll have more to say next week, including the latest results of my eBay/Yahoo options standoff, but the two Internet stocks hit 52-week lows last week, and are trading at multiples not seen in years. FLIR, a defense contractor, and a stock I've owned for years, qualifies as a special situation after missing analyst expectations a few weeks ago and announcing a delay in a key government contract. The stock plunged on the news, even though the company reiterated its guidance for the full year. FLIR is nearly 30% off its 52-week high.

Broadly speaking, this is how I like to rebalance: sell something in favor that exceeds its target allocation, in this case foreign holdings, to buy something out of favor, such as technology stocks. In the end, my exposure to the market is roughly the same.

To the extent that rebalancing is simply an extension of my overall philosophy of selling higher and buying lower, there's never a bad time to do it. But last week's market turmoil had the feel of a significant turning point, which struck me as propitious. If you haven't examined your own portfolios lately to review your allocation targets, I urge you to do it now. It may be a good time to reap some gains, and put the proceeds into out-of-favor sectors and stocks.