Portfolio Rebalancing: If You Haven't Done It Lately, Your Profits Are at Risk

Portfolio Rebalancing
Portfolio Rebalancing

Stock market investors have to be pretty happy about the way that 2012 turned out, with the Dow Jones Industrials (^DJI) rising 7 percent and the S&P 500 (^GSPC) climbing more than 13 percent. But if you want to hang onto those profits rather than losing them in the next bear market, don't let your portfolio go on autopilot.

Throughout two major bear markets since the new millennium began, one easy-to-follow strategy -- rebalancing your portfolio -- has helped investors smooth out the ups and downs of their investments.

Rebalancing takes just minutes to do. It's a simple maintenance plan that will make a big difference in reducing the amount of risk among your investments.

Success Doesn't Mean Picking Superstars

Most investors think that the key to successful investing is picking blockbuster stocks before they make massive run-ups in their share price. Professional investors with extraordinary stock-picking talent get all the headlines and media attention.

But you don't have to try to be the next Warren Buffett to succeed with your investments. Far from it, in fact.

Financial research over the past two decades has confirmed that when it comes to generating returns, the most important factor is dividing your assets across broad categories of investments. We're talking about spreading your money smartly across stocks, bonds, and cash.

Once you make those big-picture decisions, the additional impact of making above-average choices within those broad asset classes turns out to be much smaller than you'd think.

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Investors have already picked up on the benefits of this idea. The major migration away from actively managed mutual funds and toward index-tracking ETFs has come largely because investors see that matching the market's performance not only produces adequate returns over the long haul but also does so in a much more cost-effective way.

But for asset allocation to work, you have to stay close to your targeted allocations. Otherwise, big gains like last year's stock-market advance can leave you overexposed in equities, which would leave you with outsized losses if the stock market tumbled. That's where rebalancing comes in.

It's a Good Time to Rebalance: Here's How

There are two main ways to rebalance your portfolio.

The first method involves simply looking at your investments and comparing your overall allocation to your targets. Then, you sell down investments that are over their targeted allocation and invest the proceeds into investment classes that have fallen below their allocation targets. This method works even if you're not adding new money to your portfolio on a regular basis.

The second method works well if you make regular additions to your investments. After identifying which asset class is underweight, direct your future contributions to your account to go automatically into that particular asset class. So for instance, if your target allocation is 50 percent stocks and 50 percent bonds and you find that the stock portion of your account has grown to 60 percent of the total, then make sure all of the money you add to your portfolio in the coming months goes to bonds. That way, your portfolio will slowly but surely come back into balance.

Act Now, Take Profits, and Lose Risk

It's easy to procrastinate on rebalancing, even though it doesn't take very long to do. But the benefits are huge, because essentially, rebalancing involves selling certain investments when they're trading at very high prices and replacing them with newly purchased investments trading cheaply.

Since you can never tell when the next big shift in the markets might come, it's best to prepare while you can so your risk levels are where you want them.

So if it's been a while since you took a close look at your portfolio, now's a great time to consider rebalancing. Doing so could mean the difference between hanging onto your hard-earned profits and losing them whenever the next bear market rears its ugly head.

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Follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger.