Do This and Avoid the Next Lost Decade

Many are referring to the past 10 years as a "lost decade" for stocks. Certainly, the way that major market indexes like the S&P 500 and the Dow Industrials have behaved since 1999 supports the idea that stocks have been a lousy place for investors to put their money.

In response to the lost decade, investors are flocking to alternatives like bonds, gold, and cash. Yet before you write off stocks for good, you should consider this: All you would have had to do to turn that negative performance into a gain for stocks is to do one simple thing -- a thing you ought to be doing regularly anyway.

The importance of rebalancing
Here at the Fool, we often talk about the benefits of asset allocation as a fundamental foundation of your overall investment strategy. As much attention as people pay to exactly which stocks to buy for your portfolio, studies have shown that the way you divide your assets between stocks, bonds, and other investments is responsible for over 90% of the variation among investor returns. In other words, it's way more important to pick broad categories than to find the top stocks within those categories.

Yet even if you do come up with the ideal asset allocation for your portfolio, that doesn't mean you can let your investments run on autopilot for the rest of your life. Inevitably, the movements of the financial markets will create imbalances, pulling your actual allocations away from the targets you originally set. If you don't do something to fix those imbalances, then over time, they can get quite severe -- and worse, they can leave you overexposed to risks you never contemplated when you put together your strategy in the first place.

In fact, if commonly followed measures like the Dow and S&P could just rebalance their portfolios, we might never have seen a lost decade at all.

The drawback of indexes
The thing about the Dow and the S&P is that the rules that govern which stocks are included, and in what proportion, largely prevent them from incorporating anything resembling rebalancing into their formulas. The Dow's value is at the mercy of the stock prices of the component stocks; if a particular stock price rises substantially, then it will play a larger role in determining the Dow's overall value.

Although the S&P index is calculated differently, the result is the same. Given the index's market-cap weighting, a company that grows bigger has a larger impact on the index's value. Only after a stock falls does its contribution to the index become smaller.

Unfortunately, that's often the opposite of what you'd like to see happen. Over the weekend, the New York Times took an interesting look at the stock market over the past 10 years. It noted that the four sectors that represented two-thirds of the entire value of the U.S. stock market back in 1999 -- technology, financials, telecommunications, and consumer discretionary stocks -- have been among its worst performers. Sectors that were underweight, however, such as energy and consumer staples, have done correspondingly better. Take a quick look at the following Dow components as examples:

Source: Yahoo! Finance.

Similarly, automaker Ford (NYSE:F) lost over 9% per year since 1999, as a prime example of a company relying on discretionary purchases from consumers.

If the Dow and S&P had been able to rebalance its overweighted biases 10 years ago, then it would have had a greater weight on the sectors that performed the best and less invested in the worst-performing stock sectors. That slight shift could well have been enough to turn the market's losses into gains.

Don't forget
Even if major indexes can't rebalance, that doesn't mean that you shouldn't. Although you don't need to be obsessive about rebalancing your portfolio, taking a look at your asset allocation after major market moves -- like the rally we've seen this year -- can ensure that you only take risks within your comfort zone. In addition, a good rule of thumb is to rebalance your portfolio once a year. That simple step might well save you from a lost decade sometime in your future.

In saving for retirement, you can't afford to goof up. Find out what John Rosevear thinks could be the biggest mistake you'll ever make.