Think of your portfolio as a loaded washing machine. If the clothes are packed evenly inside, your laundry runs smoothly. But if its load gets out of balance, too heavily weighted on one side or the other, the machine can start shaking itself to bits, lurching around the room, and generally creating a sudsy mess.
Same goes for your investments. As the market traverses its annual ups and downs, your carefully calibrated asset allocations can get out of whack -- and endanger your long-term returns.
Beware of runaway investments
If you use your asset allocation strategy to come up with target percentages for each of your funds, you'll find that after a year, your portfolio will look quite different than it does now. And that means it's time for that great annual year-end tradition. No, not the annual Polar Bear Plunge, but your yearly portfolio rebalancing.
Exactly what you'll need to do depends on how your various funds perform. For example, if stocks have fallen, then your stock allocation percentage will end up below your target proportion, while other investments like bond funds will take up a greater chunk of your holdings than they initially did.
To keep your portfolio from getting too far off course, you'll need to rebalance all of your fund selections back to their original target weightings.
Regain your balance
You might wonder why having your portfolio allocations change over time is a bad thing. Since it's impossible to keep your allocations in line with exact targets for any significant period of time, it makes sense that some investments will eventually rise to the top.
Furthermore, since the imbalances tend to favor the investments that have done the best over time, it may seem appealing to let your winners ride, in hopes that they'll continue to outperform.
But if your portfolio slides out of balance, it may no longer reflect your tolerance for risk. If a rising stock market turns your original 50/50 asset allocation into a 70/30 allocation, you're a lot more exposed to future moves in stocks. That runs counter to the whole point of having an asset allocation strategy in the first place. Moreover, the sharpness of any subsequent losses can leave you surprised and annoyed that you didn't take steps to fix the problem when you had the chance.
Because of these dangers, many financial planners recommend that their clients rebalance their portfolios regularly. Provided you don't make additions or withdrawals, rebalancing every year or so is probably enough to help you avoid straying too far from your target allocations.
Sure, it's about as exciting as washing lettuce (and not even that swanky romaine kind). But rebalancing ensures that you adhere to the "buy low, sell high" concept. If your portfolio becomes heavily tilted toward more overpriced sectors, you'll miss out when underperforming segments of the market stage a comeback. That's why it pays to keep your portfolio in line with your long-term goals.
The nuts and bolts of portfolio rebalancing
The easiest method for rebalancing your holdings simply involves selling shares of top-performing funds, then using the proceeds to buy more of the underperformers. If you're still adding money to your investments, there's an even easier way to set your holdings back on an even keel. If one fund gets underweighted, send all your new money just to that fund until it's back in balance.
Either way, you'll want to make sure your portfolio keeps running smoothly -- if only so you don't end up getting soaked by an unpredictable market. And hey, if you find you've made a mistake in choosing one or more your funds, it's not the end of the world. Next, we'll show you how to know when to sell funds.