While there's a wealth of often-contradictory advice available about how to choose the right investments, one piece of advice is common: diversification can help you avoid risk. The degree to which you diversify is controversial, but the core idea is widely held: investing everything into a single investment adds risk.
This is one reason why a simple investment in an S&P 500 index fund is a good choice for many novice investors—especially if they don't want to spend time researching potential stocks—but even with that investment, you're getting a small piece of 500 stocks for every dollar you invest. That's also diversity.
If you have, or plan to have, any other interesting mix of stocks, bonds, and investments, you've probably heard the advice to "choose the balance of your portfolio carefully". One rule of thumb is to move your investments from risky to safe (often from stocks to bonds) a little bit every year, to protect your assets as you get closer to retirement age.
What is a Stock Portfolio?
A stock portfolio is the collection of your investments. It may be individual stocks, index funds, ETFs, bonds, gold bullion, whatever.
Portfolio rebalancing is the practice of changing the percentage of your money in each investment or investment class to match an ideal. Suppose you decide you want 50% of your investments in the Vanguard 500 Index Fund, 25% in individual stocks, and 25% in municipal bonds. You may look at your portfolio twice a year, in June and December. In the first half of 2014, your index fund may have grown to 60% of your investments (yay!) and your bonds may have shrunk to 15%.
If you were to rebalance, you'd sell some of your VFINX and buy more munis. Why?
A Healthy Mix of Stocks, Bonds, and Other Investments
The goal of diversification—the point of rebalancing your portfolio—is to reduce your exposure to risk without harming your potential for profit too much. In principle, when stock values rise, bond values go down and vice versa. The philosophy of the market seems to be that people are willing to expose themselves to the risks of stocks when the profit potential is high enough, but when that potential is too low, they prefer the lesser returns but lower risk of bonds.
Similarly people who invest in gold or silver do so because they believe that precious metals have an intrinsic value that stocks and bonds do not. (Then again, during a zombie apocalypse, medical supplies, canned food, and clean water will be more useful than gold bricks, silver coins, or stock certificates.)
The value of diversification depends on how long you can afford to invest. If you're 20 and plan to invest for 30, 40, or 50 years, weathering ups and downs of the market is much easier than for someone who's 50 or 60 and wants to retire in a few years.
One compounding factor that diversification articles rarely explain is how taxes affect investments. If you have a tax-free or tax-deferred investment, the value of a municipal bond is much different, as its rate of return doesn't have to account for capital gains taxes.
There's no single general rule that applies to everyone to determine a healthy portfolio mix. Your tolerance for risk, your financial situation outside of investments, and your goal for retirement (buy an island, buy a motor home, live in the spare bedroom of your most responsible kid) all determine what a good portfolio looks like.
Set a reminder on your calendar. At least once a year, consider your current positions, how you've done, where you'd like to go, and if you need to change your investments to further your goals.
Why Rebalance Your Investment Portfolio?
Rebalancing your portfolio once in a while has several advantages. It reminds you to review your investments and your goals. You can reduce risk, if you find yourself overexposed in one type of investment. You can increase your profit potential, if your current investments are too conservative. You can even redirect future investments more profitably, if you're not satisfied otherwise with what you have.
Remember though, that selling stocks in December also has pros and cons.
Cons of Portfolio Rebalancing
Rebalancing isn't always helpful, however. You'll pay broker fees, at least. You may also pay fees for any mutual funds you own, unless you follow the rules (holding them long enough, et cetera). You may have to pay capital gains taxes, depending on what investments you hold and how you hold them.
Worst, you tend to sell off winners to buy losers. (Take a lesson from the Russell 2000 promoting great stocks to the Russell 1000, which can hurt investors who hold the Russell 2000 index funds.) That last point is subtle but important. If you bought an undervalued stock and it's taken off in the past six months (maybe it's not a tenbagger stock, but it's a two or three bagger), is now the right time to sell it? Maybe it is. Maybe it isn't. Or if you haven't been reinvesting dividends, maybe you have some extra money to put somewhere else.
If you follow the rules of Warren Buffett as expressed in the book The New Buffettology, there's no point in selling a really good investment, ever. If you bought it at a price that's below its intrinsic value, and if it keeps returning good returns every year, keep it!
Yet if you've bought a turnaround company (Trendshare is pleased with NLS and is still long on it, as of this writing), there may come a point at which it won't return as much value every year because it's fairly priced. Maybe it's not an excellent company. Maybe it's paid you back. It's not a bad stock to own, but there may be better options in the market.
Similarly, just because one investment option in your portfolio didn't do well in comparison this year, there's no guarantee that it'll do better if you put more money into it. Maybe the company just isn't strong. Maybe you're better off replacing the low performer with something else.
The real benefit of thinking about portfolio rebalancing is reconsidering what a healthy stock portfolio looks like for you.
What is a Healthy Stock Portfolio?
A healthy portfolio reduces risk to your comfort level. It provides the aggregate return you want to meet your financial goals. Above all, it includes only the investments that you understand and are comfortable with.
For a value investor looking for great companies at good prices, maybe you're looking for turnaround plays or underpriced great performers. By examining your portfolio critically every few months—and making changes if necessary—you give yourself the flexibility to adapt to different business conditions, different life conditions, and changing goals.
If you want an invest-and-forget-it approach, buying a couple of index funds will likely meet your needs over the long term. Otherwise, occasionally reviewing your portfolio gives you tremendous power to build wealth for the long term. The market changes as business conditions change. Small course corrections will keep your goals aligned with reality.
← Should You Sell Stocks in December? | How Does Portfolio Churning Affect Your Returns?→
More Articles about Investing
How Much Money Would Change Your Life?
What is a Stop Loss Order?
Why Should You Roll Over An Employer 401(k)?
What is a Stockbroker
What Does a Trump Administration Mean for the Stock Market?
Most Popular Articles
What is Active Investing?
What is a Good Annual Rate of Return?
Should You Invest in Gold or Silver?
Should You Invest in the Highest Dividend Paying Stocks?
Should You Sell Stocks in December?
How Do Stock Brokers Make Money?
Why Does the Dow Change the Stocks it Tracks?
The Current Price of Silver Today
Why Do Some Companies Not Pay Dividends?
How Do You Make Money with Penny Stocks?