Do This Before You Buy (or Sell) the Rally

If you wished for a return to the heady days of the bull market from a few years back, you've certainly gotten it over the past couple of months. What many figured would be a short-lived bounce off the March lows has turned into a 35% explosion to the upside.

But with the downs and ups of the market, how much of your money should you have in stocks right now? If you look at the rally and say "as much as possible," then you haven't learned as much from the bear market as you should have.

Getting the right allocation
This month's brand-new issue of Rule Your Retirement, to be released this afternoon at 4 p.m. ET, takes a closer look at deciding on an asset allocation strategy for your portfolio. Figuring out how to divide your money among stocks, bonds, cash, and other asset classes may sound easy compared to deciding exactly which stocks and other investments you'll buy. Yet asset allocation actually has a huge impact on your portfolio's returns -- as well as its inherent risk.

At first, the answer seems simple: Put it all in stocks. For example, between 1926 and 2007, the return on stocks was almost double that of bonds, and nearly three times what short-term Treasury bills paid. So clearly, the greater the percentage of your money you had invested in stocks, the better your return.

But return is only half the equation. If having a 100% stock portfolio makes you panic during bear markets, you'll end up with big losses. That's why knowing how much risk you can endure is crucial in putting an upper limit on your stock exposure.

Sweating the details
So once you decide you should own some other investments, such as bonds, how do you decide how much to put where? In this month's newsletter, Fool expert Robert Brokamp notes that you might not give up much return on safer allocations.

For instance, a portfolio holding a 60%/40% mix of stocks and bonds outperformed a 40%/60% portfolio by just 0.4 percentage points per year over the past 30 years. If you want less exposure to the volatility of the stock market, you might willingly give up such a small amount of return to get it.

What's hard, though, is keeping your allocations on track over time. As a ridiculous example, say you decided on a 50/50 split between stocks and cash. Two years ago, you put $5,000 in a bank account paying no interest, and invested $1,000 each in these five stocks:

Source: Yahoo! Finance.

After two years of terrible stock returns, your 50/50 allocation would now be about 26% stocks and 74% cash. And while this example is extreme, even those who use broad-market investments such as index funds have seen similar shifts. Unless you take action, your portfolio won't act the way you expect it to -- at just the time you might need it to perform well.

Make the right choice
To get your asset allocation back on target, Robert offers three pieces of advice for investors. One of them is to make sure the stocks you own still have the same potential they did when you first bought them. Replacing a losing stock for a more promising one can help you improve your returns.

For instance, Warren Buffett recently said he believed that Wells Fargo (NYSE:WFC) was the stock he'd pick to invest his whole net worth in. If you believe his investing thesis, then you might want to take your losses on other bank stocks like Citigroup (NYSE:C) and Bank of America in the hope that you'll get better performance from Wells. If you look closely, you might find that you don't have the best stocks in your portfolio.

To see Robert's other advice on crafting the perfect asset allocation strategy, you won't want to miss the new issue of Rule Your Retirement. Subscribers have full access to a ton of resources, including special reports, back issues, and exclusive discussion boards to learn and share new ideas. And becoming a subscriber is as easy as clicking here -- we'll even give you a full month free to get acquainted with the service.

With the market moving full-speed ahead, you might still feel antsy about getting back into stocks. Asset allocation can make you feel more secure about investing while also making sure you don't take on too much risk.

For more on retiring well, read about:

• How you can wind up wealthy.
• This monster could eat your retirement.
• Is it time to cash out of stocks?