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Sometimes, the little things in investing can seem kind of boring.

Many of us -- I'm no exception -- would rather talk about Apple CEO Steve Jobs' new venture into social networking and its prospects for broadening the company's reach, or spend time hunting up fat-yielding dividend stocks like Kimberly-Clark, which has raised its dividend a whopping 38 years in a row.

Those are interesting, exciting topics for investors. Things like asset allocation or rebalancing? Not so much.

But those are the kinds of little things that can make a big difference -- especially when those little things get to compound over time.

Rebalancing, and why it matters
Rebalancing, simply put, is the art and science of periodically resetting your portfolio to your intended asset allocation. A good asset allocation strategy is key to getting steady returns with well-managed risk over time, but price movements over time can mess up your ratios.

For instance, suppose that your plan called for a certain allocation to cyclical industrial stocks, and a year ago you'd split it 50-50 between Ford (NYSE: F  ) and Dow Chemical (NYSE: DOW  ) .

A year later, how's it look? Ford's spectacular turnaround may well be one for the history books, as the company has continued to launch top-notch products while staying intensely focused, increasing sales and capturing market share from competitors like Toyota (NYSE: TM  ) around the world. And the stock has followed along nicely, going from about $7 to about $12 over the period.

Dow Chemical, on the other hand, has been more of a mixed bag, taking investors on a wild up-and-down sleigh ride that, a year later, has ended up pretty much where it started. A strong first quarter, ironically, led to a price decline as investors began to question the company's long-term prospects. Second-quarter results that came in below expectations -- lagging key competitors like DuPont (NYSE: DD  ) -- seem to have left investors scratching their heads, as the share price has gyrated around the $26 mark. Still, there may be reason for optimism, as the company reported double-digit growth in seven of its eight business segments and could see solid appreciation going forward.

Long story short, your hypothetical allocation now might be more of a 65-35 ratio than the 50-50 ratio called for in your plan. And while Ford shareholders might object to this suggestion, this might be a good time -- assuming you still believe in the long-term prospects of both stocks -- to sell some of that Ford stock and buy a little more Dow Chemical. Not only will that move restore your intended 50-50 allocation, it'll -- pay attention here -- get you more Dow Chemical while it's relatively cheap.

It's kind of like an automatic value investing system, or as my fellow Fool Dan Caplinger put it recently, like shopping at the mall, buying things when they go on sale.

The right way to rebalance
Foolish retirement guru Robert Brokamp is a big proponent of rebalancing for long-term portfolios, and he has an article in the new issue of the Fool's Rule Your Retirement newsletter that digs into the pros and cons of rebalancing strategies in detail.

There's definitely a case to be made that rebalancing every year or so isn't always the best move, in retrospect; there's some merit to the old Wall Street adage to "let your winners run." But as a consistently applied discipline, rebalancing will tend to reduce your overall risk and increase your returns over time.

Yes, I said "increase your returns," despite the sense that you might sometimes be selling winners to buy laggards. It may seem like rebalancing doesn't buy you that much -- and in a short-term sense, it usually doesn't. But when you rebalance your portfolio every year or two over a few decades, it can make a sizable difference -- thanks to the power of compounding.

Consider: Robert's article looks at an example where $100,000 invested in 1972 would have yielded about $4.3 million today -- unless you rebalanced every year, in which case you could add another $330,000 to that total. While $330,000 may not seem like much compared to $4.3 million, it's still three times your original investment. Who wouldn't like to get to retirement with another $330 grand to spend, especially when that money only takes you about an hour a year to earn?

If you'd like to learn more about rebalancing -- and a useful key to managing your portfolio's risk that you might not have thought about -- check out Robert's article in the new issue of Rule Your Retirement. Rule Your Retirement is a paid service, but you can get full access right now with a no-obligation 30-day free trial. Just click here to get started.

Think you've "outgrown" the need to rebalance? Think again -- Dan Caplinger knows why retirees still need stocks.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor John Rosevear owns shares of Ford and Apple, which are both Motley Fool Stock Advisor recommendations. Kimberly-Clark is a Motley Fool Income Investor pick. You can try Rule Your Retirement or any of our other Foolish newsletter services free for 30 days, with no obligation. The Motley Fool has a disclosure policy.

Read/Post Comments (8) | Recommend This Article (34)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 08, 2010, at 1:53 AM, PoundMutt wrote:

    Why does MF allow those annoying advertisements like those above?


    "If you'd like to learn more about rebalancing -- and a useful key to managing your portfolio's risk that you might not have thought about -- check out Robert's article in the new issue of Rule Your Retirement. Rule Your Retirement is a paid service, but you can get full access right now with a no-obligation 30-day free trial. Just click here to get started."

  • Report this Comment On September 08, 2010, at 4:03 AM, RCS2rocks wrote:

    I would venture to say that the latter is of more value than all of the former!

  • Report this Comment On September 10, 2010, at 1:05 PM, rsiconcrete wrote:

    I think Peter Lynch called it watering the weeds. Rebalancing to give yourself average results.

  • Report this Comment On September 11, 2010, at 9:18 AM, jpaa74 wrote:

    Does this calculation take in to account commission costs, and taxes that had to be paid when re-balancing the portfolio, and the lost compounding effect due to those costs?

    If it does, then all is well.

    If it doesn't, then this is really false advertising/marketing, which would be really bad, and I'd lose a lot of respect for the Fools...

  • Report this Comment On September 11, 2010, at 10:32 AM, Notfooled1 wrote:

    In effect, you are saying to cut back on your winners and to buy more of your losers. This "strategy" contradicts what most winning investors know about the market. Isn't that foolish?

  • Report this Comment On September 12, 2010, at 7:23 PM, 11x wrote:

    Rebalance what every year? Sell Wal-Mart stock and buy KMart, sell Intel and buy Cyrix, sell Cisco and by 3Com?

    Generally, when advisors discuss "rebalancing" they are referring to the mix of security classes, ie, stocks, bonds, commodities, etc. You may be able to break this down even more and break stock classes down into sectors (ie financials, consumer staples, discretionary, etc), but to sell a winning stock and buy a losing stock doesn't seem the way to go. Any "test" or backtesting of switching out winning stocks for losing stocks and getting an extra $300,000 doesn't mean anything to me. I could run my own ficticious backtest and get completely different results. You could either backtest wth buying companies that turned themselves around, or backtest with buying companies destined for the junk heap and wound up living in the streets for retirement.

  • Report this Comment On September 13, 2010, at 9:02 PM, ilovesumm wrote:

    I have had poor stocks that should have caught the good ones but never did. Meanwhile the good ones just kept soaring. If I would have sold the good ones I would have had a tax bill and a flat return.

    The old expression , don't throw good money after bad comes to mind.

    I have heard of brokers trying to sell me on this but have never heard of any legends (Buffett, Lynch etc ) employ it.

  • Report this Comment On September 14, 2010, at 1:13 PM, FiveHappyDaze wrote:

    The developments in the equity market over the past six months and the many reports on the economic and investing outlook for the year ahead may prompt some of you to consider rebalancing your portfolios.

    When you rebalance your portfolio, you're reviewing it to determine if your asset allocation is still intact. Normally, the asset mix would change through time due to the returns made on the different asset classes in the portfolio. Therefore, you will need to make adjustments, which are buy and sell different assets in order to restore it to its original allocation to keep your portfolio in line with your investment objectives.

    For instance, you invested 50% of your portfolio in an index linked fund and the other half in a fixed income fund. Within a year or two of making your investments, the stock market picks up high. As a result, your index linked fund investment grows and takes up a bigger proportion of your portfolio. In the same time frame, your bond fund investment registers only minimal growth.

    Therefore, the asset allocation of your portfolio has changed from its original mix; from a balanced portfolio, which is 50% equity and 50% bonds, it has become a more aggressive portfolio like 70% equity and 30% bonds. It may no longer be in line with your risk tolerance and you could be in danger of not meeting your investment goals.

    Another advantage of rebalancing is that it enables you to lock in the gains made on growing investments and buying other assets at a cheaper price.


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