Everybody knows that the stock market hasn't been terribly kind to investors for a long time. But even through two major bear markets in the past decade and despite a lot of uncertainty going forward, one strategy has helped smart investors make the most of a rocky environment: rebalancing your portfolio.
Best of all, rebalancing isn't complicated at all -- and it's easy to do. The only thing is that you have to remember to do it regularly -- or else sometimes, you'll find that you've run out of time.
Investing made simple
Most investors spend huge amounts of time trying to figure out which stocks are likely to do best. Clearly, many veteran stockpickers have distinguished themselves by producing strong results over long periods of time, so there is some skill in choosing strong investments and avoiding weak ones.
But even if you're not an expert stock jock, don't panic. According to landmark financial research done 20 years ago, the lion's share of returns come simply from which types of assets you invest in and how much of your money you put into each type. That shouldn't come as any big surprise, especially given how the majority of mutual fund managers have failed even to match the performance of major benchmark indexes -- let alone beat them.
So if your main focus is simply on picking how much money to allocate to stocks, bonds, and other alternatives like commodities and real estate, what's the secret to surviving bad markets like we've seen ever since the turn of the millennium? The answer comes from a simple move: making sure those asset allocation targets stay on track by doing a regular portfolio rebalance.
Showing you the money
Even though there are academic studies that have confirmed the value of rebalancing, this isn't just a theoretical idea. As the Fool's Rule Your Retirement newsletter looked at in greater detail last year, simply rebalancing your portfolio gave investors an extra $330,000 from an initial $100,000 investment made almost 40 years ago.
More recently, one way investors survived the Great Recession was because they had rebalanced their portfolios. By selling high-priced stocks near the 2007 highs and then buying them back at or near their 2008 and early 2009 lows, investors followed the old "buy low and sell high" maxim perfectly.
Toning down the risk
But rebalancing isn't just about maximizing returns. It also reduces risk -- especially in stock portfolios.
Whenever you have a portfolio of individual stocks, you'll almost inevitably have some big winners -- and as those winners go up in value, they'll make up an ever-increasing percentage of your portfolio. That, in turn, can lead to your taking on a much higher level of investment risk than normal.
For instance, if you had invested 5% of your portfolio in Netflix
But at that point, your allocation to Netflix would have jumped to more than 22%. Such a huge concentration in one stock would have left you exposed to huge amounts of risk -- risk that bit shareholders when the shares came crashing back down over the past several months.
Nor is Netflix a unique situation. Consider these stocks and what a 5% allocation would have done since the March 2009 lows:
Total Return Since March 2009
5% Allocation Became
Las Vegas Sands
Green Mountain Coffee Roasters
Chipotle Mexican Grill
Sources: S&P Capital IQ as of Dec. 9 and author's calculations. Assumes other investments in portfolio had zero returns.
Moreover, those figures reflect returns after taking into consideration the recent slides in some of those stocks. If you looked at Green Mountain a few months ago, it would have made up an even greater allocation -- and you would have suffered the consequences if you held all your shares all the way down.
Be smart about rebalancing
You don't have to rebalance all the time. But thinking about it occasionally -- especially after your shares have seen big gains -- can help you preserve your profits. In the long run, that can make a huge difference in whether you get rich the way you want.
Rebalancing works best when you have a big gain in your portfolio. To find a great prospect for next year, take a look at our newest special report, "The Motley Fool's Top Stock for 2012." This report is absolutely free, and even more important, it's not the sort of thing you want to wait to read. Click here now or you may regret it later.
Fool contributor Dan Caplinger is making his year-end list and checking it twice. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Limited Brands, Ford, and Chipotle. Motley Fool newsletter services have recommended buying shares of Netflix, Chipotle, Ford, and Green Mountain, as well as creating a lurking gator position in Green Mountain. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy has no regrets.