Adjusting Fund Portfolio Can Be Tricky Balancing Act.

HERE'S one rite of the millennium you won't want to miss: rebalancing your mutual fund portfolio.

OK, if you have a suite booked at the Plaza or you plan to see the Jan. 1 sunrise from the top of a mountain, put that first. But as the excitement dies down after the holidays, set aside time for checking whether your fund investments are up to date. Better still, do it now and combine it with any year-end tax moves you want to make.

After the way 1999 has played out in the financial markets, your money may not be allocated as you intend it to be, even if you simply sat tight the whole year.

"Asset allocation is the most important decision that you as an investor make," said Paul Merriman, a Seattle adviser and fund manager who publishes the newsletter FundAdvice.com. It's the key to seeing that your money is diversified according to your goals and temperament, rather than just allowing it to get swept along by the market current.

Suppose, for the sake of illustration, that you began the year with a $100,000 nest egg divided 50-50 between typical stock and bond funds.

Since the start of the year, the Bloomberg average of more than 5,700 stock funds has gained 20 percent, while the Bloomberg average of more than 3,500 bond funds has lost 2 percent. So you now would have $60,000 in your stock funds and $49,000 in your bond funds.

Thanks entirely to the machinations of the market, your allocation has shifted to 55 percent stock funds, 45 percent bond funds.

That's a significant change by itself. Let this sort of thing go on for a few years, and your original asset-allocation plan is gone. The better your stock funds fare in this mighty bull market, the faster that happens.

I'm not recommending 50-50, by the way -- it's for illustration only. The right proportions for you will always depend on your own goals and circumstances. If you buy an "asset allocation" fund that purports to keep your money deployed in a balanced way, check carefully to see that its formula fits your needs.

To keep their asset allocation on track, many professional money managers rebalance frequently, in some cases every day. Individual investors should rebalance far less often, if only because they have to take capital gains taxes into account on every transaction.

In a tax-deferred individual retirement account or 401(k) plan, where current taxes aren't an issue, there's a good case in our sample account for taking time one of these days to shift $5,500 from stock funds to bond funds, and restoring a 50-50 allocation.

For taxable investors, independent fund analyst Sheldon Jacobs in Irvington-on-Hudson, N.Y., offers an ingenious suggestion: Instead of automatically reinvesting your stock funds' year-end gains distributions in the funds from which they came, direct the proceeds to a money fund or bond fund. That way, you can rebalance roughly using money you have to pay taxes on anyway.

During bull markets, many people who intended all along to rebalance around New Year's Day find they have no appetite for moving money out of winning investments into laggards. In the morning-after atmosphere of a weaker market, though, they may be sorry they didn't.

Diversification makes sense even in good times. Don Phillips, chief executive of Morningstar Inc. in Chicago, said 1,865 individual stocks, or one in every four the research firm tracks, dropped 20 percent or more in the third quarter of 1999. But only six stock mutual funds, or about one in a thousand, dropped by that much. The difference: the funds' risks were spread over many stocks.

If you're serious about staying diversified, you might also take a look inside the funds you own to see how the makeup of their portfolios has changed.

There's another variable to put into your rebalancing calculations.

One of rebalancing' s great virtues is the way it can serve as an antidote to performance-chasing, the natural human tendency to like those funds the best that have done the most for you lately.

"If you base your search for funds on recent performance, the chances are good that most or all of the funds you investigate will start to look alike," said Merriman. "That's a trap that could leave you without the diversification you need."

If you choose funds working from a consistent asset-allocation plan that you keep in balance, there's much less chance that could happen.

Dubious Future for Bonds

Any way you look at it, it's hard to see a bright future for bond mutual funds.

While stock funds and money-market funds have boomed in the late 1990s, bond funds' share of the business has shrunk faster than a tourist-trap sweatshirt.

At their mid-1990s peak, bond funds commanded almost 30 percent of the assets invested in all types of funds, as measured by the Investment Company Institute. At the end of October this year, their share was 13 percent.

Since the end of 1994, bond fund assets as tallied by the ICI have risen 59 percent. Over the same span, the Bloomberg average of bond funds, which tracks the combined return produced by asset appreciation and dividends from bond interest payments, has gained about 39 percent.

In other words, two-thirds of bond funds' modest asset increase has come from price appreciation and only about one-third from new money flowing into the funds.

In recent years, many fund investors looking to balance their swelling stock-market holdings have chosen money market funds rather than bond funds. By shunning bond funds in 1994 and again this year, investors have provided strong evidence that they won't accept price variability in an investment they own for conservative reasons -- as a source of stability in their overall holdings.

Chet Currier is a columnist for Bloomberg News.