The 2010s are over, and it's been a momentous decade for investors. The stock market recovered brilliantly from its plunge in 2008 and 2009, and although the move hasn't been straight up, the U.S. markets have been able to avoid big downturns. The domestic economy has been strong, and many stock indexes are at all-time records.
Many believe that we're overdue for a bear market, and 2020 has plenty of uncertainty that could lead to a reversal of fortune. Yet regardless of whether 2020 is the year that the market pulls back, there's a smart strategy to follow regularly that can help you protect gains from bull markets and defend yourself against a pullback when it comes. All you have to do is to rebalance your investment holdings to get your asset allocation back to where it belongs.
Letting your risk get out of line
When most people invest, they like to figure out how much risk they're comfortable taking and how aggressive they want to be in order to achieve their financial goals. Asset allocation strategies typically advocate that you figure out a balance between riskier and less risky assets to produce the ideal balance between return and risk. For instance, if your time horizon is relatively short and you're fairly conservative, then you might choose to have half your money invested in the stock market and the other half in fixed-income investments like bonds or bank CDs.
When the stock market goes up more sharply than less volatile investments, then it can leave you with more risk in your portfolio than you had before. For example, take 2019. The S&P 500 is up about 30%, while a popular exchange-traded fund specializing in bonds is up 9% for the year. If you started out the year with a portfolio worth $200,000 split equally between the two investments, then your stocks would be worth about $130,000 and your bonds would be worth $109,000. Notice that that split is no longer the original 50%/50% you had at the beginning of the year. Instead, it's about 54% stocks and 46% bonds.
If you go even longer without rebalancing, the impact can be even larger. Over the past 10 years, a 254% total return for the S&P 500 and a 42% rise for the bond ETF would result in a portfolio having more than 70% allocated to stocks if you hadn't rebalanced throughout the decade.
What rebalancing does
The problem with letting your stock allocation get too high in a bull market is it leaves you more vulnerable to a subsequent downturn. That's what happened to many people in 2008 and 2009, because the mid-2000s had featured strong stock market returns that led to high stock allocations for those who forgot to rebalance.
By contrast, if you rebalance, you're essentially selling some of your assets at high prices to buy other assets at lower prices. Using the example above, if you haven't rebalanced in 10 years, then selling off enough stock and buying fixed-income investments to return to a 50%/50% split will result in having a lot less exposure to the stock market if it subsequently falls.
The time to act is now
The longer it's been since you last rebalanced your portfolio, the more important it is to take action now. For those using less sophisticated asset allocation strategies that only look at stocks and bonds from a big-picture perspective, then all you'd have to do is to make a couple of transactions. If you break things down more narrowly to look at sub-asset classes like U.S. and international stocks or large- and small-cap stocks, then you might have more to do in order to get your portfolio back in shape.
There's no guarantee that a bear market will come in 2020, but that doesn't make it any less important to take action now. By rebalancing your portfolio, your risk will be exactly where you want it to be -- and you'll be in a better position no matter what happens to the stock market in the short run.