The stock market has given investors some of the best performance over the past nine years that they'll ever see in their lifetimes. At times like these, the last thing on many investors' minds is considering the risks in their current portfolio. Yet those who failed to take measures to manage their risk following the massive bull market of the mid-2000s ended up regretting it when the financial crisis dealt their investments a crushing blow in 2008 and early 2009.
No one is telling you that it makes sense to sell off your entire stock portfolio because you fear that a bear market might be coming. Rather, there's one simple way to manage your risk that involves much less dramatic moves, yet it still goes a long way toward ensuring that you'll get maximum benefit from the stock market's past outperformance as well as appropriate exposure to the market's future returns. Just rebalance your portfolio, and you'll be in a much better position whatever happens going forward.
What rebalancing means
Rebalancing your portfolio refers to ensuring that the allocations of investment capital across your investments are in line with the target allocations that you've set in your overall investing strategy. For instance, if you've decided that you want to maintain a 50-50 split between stocks and bonds, then rebalancing involves looking at your current mix of stocks and bonds and seeing where it is compared to that 50-50 target. If the value of your bonds is higher than the value of your stocks, then you'll sell bonds to buy stocks. If the stocks have gone up relative to the bonds, then you'll do the opposite, selling from the stock side of your portfolio to purchase bonds.
Rebalancing can be as simple or complicated as your investing strategy. Some investors have detailed target allocations not just to broad asset classes but also to certain sectors of the stock market or even across certain individual stocks. The more detailed your target asset allocation is, the more complicated it is to rebalance -- but it's also more important when you're committed to keeping overall risk under control.
Why rebalancing works
Why rebalancing is so effective has to do with the way that most investors find success in their investing. You might think that the most important aspect that determines whether someone makes more or less money in their investing is which specific stocks they buy for their portfolios. That idea makes sense intuitively, because the best-known investors have developed an uncanny ability to find opportunities from particular companies that turn out to be among the best long-term picks in the market.
Yet as it turns out, the most important element of investing success isn't stock-picking. Rather, it's deciding how much money you allocate across broader investment asset classes, such as stocks, bonds, real estate, and commodities. Individual investments can rise and fall haphazardly, but over time, well-diversified pools of similar assets produce steadier, more predictable returns. Moreover, mixing different asset classes can reduce risk while enhancing returns.
Why now's a great time to rebalance
The best time to rebalance your portfolio is when markets are at extremes. It's at inflection points that you're most likely to capture the greatest benefit from rebalancing. For instance, right now, many investors will find that their portfolios are more heavily invested in stocks than is appropriate for their risk level. Selling stocks near record highs is much more attractive than having to sell after they've lost ground.
If you haven't rebalanced your portfolio in a while, then you'll likely find that your risk levels have crept upward without your even realizing it. Taking time to rebalance right now will help you get your portfolio risk down to more comfortable levels, and it will help you avoid the disastrous results that those who neglected to rebalance suffered during the financial crisis nearly a decade ago.
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