The Best Reason to Sell the Rally Now

If you took our previous advice, then you may have already made a critically important adjustment to your portfolio once this year. Yet now, only a few months later, you may want to give some thought to doing it one more time.

Generally, rebalancing your portfolio isn't something you have to think about very often. As long as you pay attention to your current asset allocation and don't let it get too far out of whack, then you can often go a year or more without having to rebalance.

Lately, though, the market's violent moves have caused many investors' asset allocations to swing back and forth between low stock levels at market lows to much higher ones after the recent rally. As a result, if you rebalanced your portfolio earlier this year when stocks were priced much lower, you may find yourself currently exposed to a lot more risk than you might feel comfortable with.

When it pays to rebalance
The math behind rebalancing is simple. Say, for instance, you're aiming to divide your investments 50/50 between bonds and stocks. Over time, if one of those asset classes does better than the other, then you'll find yourself out of balance.

Occasionally, those imbalances can come about over extremely short time periods. As an extreme example, consider a simple portfolio, 50% in a bond ETF, and 50% split among seven stocks. If you rebalanced your portfolio at the end of February, you might think that you should be fine for the rest of the year. But look just how far out of balance your portfolio is after less than six months:

Source: Yahoo! Finance as of Aug. 10, 2009.

When you add it up, the total value of your stock portfolio comes to $23,231, more than triple its original $7,000. At the same time, most bond ETFs have lost value; $7,000 invested in a long-term Treasury ETF would be worth just $6,391, even with interest paid over the interim.

Doing the math, you'll find that your original 50/50 allocation has turned into a nearly 80/20 allocation weighted toward stocks. And while you'd need to have had an extremely concentrated portfolio to have gotten returns anywhere near what those seven stocks collectively earned, even the more modest rise in the S&P 500 would have left you with more than 60% of your assets in stocks. Even that is a big enough deviation to warrant a close look at rebalancing again.

What you missed if you stayed pat
On the other hand, if you decided not to rebalance your portfolio earlier this year in the hopes that the market would rebound and essentially do the rebalancing for you, then the rally has probably gotten your allocations back toward where they were last fall. That's good news for many who saw their portfolios take a big hit.

But when you take a closer look, you may realize that by not rebalancing, you missed out on a great opportunity. Sitting on huge stock losses, you likely would have taken money from bonds and other asset classes and used it to buy stocks. If you rebalanced again now, you'd take money out of those now-appreciated stocks and put it back into beaten-down bonds and other assets.

That round-trip would have had you buying stocks low and selling them at significantly higher prices, while selling bonds high and buying them back at lower prices. That's always a smart move. Of course, it also would have meant taking more risk during the worst of the financial crisis -- something many people weren't comfortable with.

Whether you need to rebalance now depends on what you've done in the past and how much risk you want to take with your investments. By keeping a tight rein on your investments during volatile times, you'll avoid nasty surprises that come from having a riskier portfolio than you think you have.

Fool contributor John Rosevear knows what you need to do now, and he's not holding back. Get the tough love you need to get your finances in order today.