1 Thing You Must Do With Your Stocks Every Year

Most experienced investors know it's a good idea to diversify your portfolio, because you don't want your money to be too sensitive to the performance of any single company or sector. Even if you really only care about tech companies, for example, you need to spread your money around to ensure that a sector-related collapse like we saw in 2000 with tech stocks doesn't wipe you out. However, once you properly diversify your portfolio, it requires some homework and regular maintenance to keep it that way.

What is a diverse portfolio?
A diverse portfolio fits two major characteristics. First, it doesn't have too few or too many stocks. If you only own two or three stocks, a bad quarter for one company can really hurt your account. On the other hand, if you own too many stocks -- say, 20 different companies -- you may as well simply put your money in index funds and save on trading commissions. A basket of five to 10 well-chosen stocks is a nice middle ground.

Secondly, a diverse portfolio doesn't have too much exposure to any single industry or to related industries. If you own six stocks, but three of them are highly dependent on the auto industry -- for example, General Motors, AutoZone, and CarMax -- your portfolio needs a change.

Your portfolio won't stay diverse forever
Once you're satisfied that your investments are sufficiently diverse, you still have work to do. Even though most investors know to diversify, the art of portfolio reallocation is not discussed nearly enough.

If you have a 401(k) at work, this is already done for you. Generally, when you sign up, you specify what percentage of your assets you want invested in certain funds (e.g., 25% in an S&P 500 tracker, 20% in small caps, 10% in bonds, etc.). Well, if the stock market skyrockets, your shares of the S&P index fund will represent more than 25% of your portfolio, as it will disproportionately increase in value relative to bonds. Your plan administrator will automatically sell some of your shares to keep the percentages as you specified.

An example
Let's say you buy five stocks and invest an equal dollar amount into each one. Well, as we all know, different stocks perform differently, so after a year you might not have equal holdings in one company. For example, if you had invested in Tesla a year ago, it stock would now represent much more than 20% of your portfolio, having soared 273% in that time.

Or let's say you bought equal dollar amounts of five stocks in 2003, and one of them happened to be Apple. Well, Apple is now worth more than 60 times what it was back then, so it could easily represent the majority of that portfolio. If one of the other companies doubles, you'll barely notice. The same is true of your losing positions. If you had put 20% of your money in Citigroup in 2005, it's certainly not 20% of your portfolio now. Reallocating your money will allow you to better capitalize if the share price begins to recover.

Consider this example of a diverse $10,000 portfolio of five stocks purchased a year ago (with each stock starting at 20% of the total). Notice how their allocations would have changed as a result of their performance.

Company May 2013 Price May 2014 Price
Apple

$455.71

$600.96
ExxonMobil $90.25 $102.91
Bank of America $12.39 $15.08
Target $70.35 $59.87
Pfizer $28.93 $29.96

Percent of Total Portfolio | Create Infographics.

Because this will inevitably happen to your investments, you need to spend some time every so often (once a year is good) to rebalance your portfolio. In the above example, the portfolio has grown a little too dependent on Apple and not dependent enough on the performance of Target.

Why it's important
This is important for two main reasons. First, it forces you to lock in your gains. In the above example, we would have to sell off about 17% of our Apple stock in order to bring it down to just one-fifth of the portfolio. When we do this, we're taking our Apple profits, which are now ours to reinvest, and now our portfolio isn't as vulnerable if Apple goes back down. In fact, if we sold some of our Apple stock now, and it happened to go all the way back down to $450, we'd still be ahead.

Rebalancing also lets you capitalize on rebounds in losers. Target lost about 15% of its value over the last year due to its infamous data breach and some less-than-stellar financial results. However, these are temporary issues, and if we believe in the company for the long term (as you should with every stock you own), we are betting it will rebound eventually. Well, if we bring our allocation in Target back to 20% of the portfolio, we stand to gain much more if shares return to their previous levels.

As I said before, once a year is a good interval for reallocating your portfolio. It's definitely worth spending a couple of hours once a year to lock in gains, double down on cheaper companies, and spread your risk around, and this is especially true if you've had any big winners or losers in your portfolio.

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  • Report this Comment On May 11, 2014, at 1:26 PM, JRHaley1980 wrote:

    Matt, well written article. A couple of thoughts based on what we've been taught as Fools.

    - Not sure why you say five to ten is ideal for apart folio size or that if you have 20 you might as well buy an index fund. Would submit that the number depends more on your investment strategy, time you have to spend "knowing" your companies, and what your goals are. I'm not saying 30 or 50 is better but believe that for some Fools holding three to five core companies, three to five dividend-strong companies, and five to ten "opportunities" in small, medium or large companies could be best.

    - not usually great to sell your winners unless the company has changed or the investment assumptions have changed or become invalid.

    - investing means adding money, so maybe it would be better to advise adding new money weighted toward the stocks that comprise the lower percentages so that you move toward a balanced portfolio as your portfolio grows.

    - "Doubling down" on cheaper companies is not how I would capture your intent; I think you meant to invest in the good companies that have not appreciated in line with their value. There is a difference. Target is an example - if it is assessed as a good company (by whatever Foolish criteria the investor is using) yet has been over sold due to a spike reaction to the data breach, then it would be an "opportunity" ...vice a double-down on a laggard or loser.

    Having said all of that, if you are in retirement or otherwise don't have money to add, then rebalancing by selling portions of winners and buying portions of those stocks not yet winning (note I avoided saying losers) MAY be wise depending on the value, company/business assessment, etc. for both the winners and not-yet-winners. But it COULD also be wiser to invest into the winners if they have accelerating growth, solid management, and a moat that makes for lower risk.

    Bottom line.... Thanks for making us at least Think About It!

    Sincerely, JR

  • Report this Comment On May 14, 2014, at 7:49 PM, rawbourbon wrote:

    Individual investors should not be buying individual stocks without first knowing what each company is worth on a conservative basis. Once you know what each company is worth (it's a range of fair value actually) then selling an undervalued company to buy one that may be fully valued does not make sense. Reallocating without knowing what the companies are worth makes no sense. Most people can't or won't take the time involved in learning how to value companies so they should just stick with index funds.

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