2013 has been a great year for investors in the stock market, with gains of around 25 percent for the Dow Jones industrials (^DJI) capping off a five-year bull-market rally. Many investors who had the discipline to hold their stocks after the market’s plunge during the financial crisis in 2008 and early 2009 have seen their portfolios recover to their pre-crisis levels — and keep climbing.
But if you want to preserve your investment gains, you need to learn from the mistakes of the past.
Specifically, there’s one crucial money move you need to make to realign your portfolio with the appropriate level of risk that you can afford to take with your investments. That move is rebalancing your portfolio.
The Basics of Asset Allocation
Many investors use a method called asset allocation as the basis for their overall investing strategies. Asset allocation involves breaking your portfolio into several pieces, investing each portion in a different type of investment.
Traditionally, investors split their assets across stocks, bonds, and cash, coming up with asset allocations that reflected their relative risk level. Riskier portfolios included higher percentages of stocks, while more conservative investors prefer greater allocations to bonds and cash.
For instance, investors with middle-of-the-road risk tolerance but without any need for a separate cash allocation might choose a 50/50 split between stocks and bonds, giving them growth potential from their stocks and reliable income from their bonds.
Asset allocation strategies are simple and easy to follow, but they require some attention to make sure that they stay in balance.
Over time, different types of investments will produce different returns. If one investment soars in value while another plunges, then you’ll quickly find yourself with more of the better-performing asset than you originally intended. That might sound ideal, but it actually creates risk that you might not even know is there until it’s too late — unless you rebalance.
How Investors Got Burned in 2008
We saw the downside of the risk of unbalanced portfolios during the bear market of 2008. Between early 2003 and late 2007, the stock market almost doubled. That was obviously a positive for the value of their investment nest eggs. But an unintended result was that many of those who had neglected rebalancing their portfolios found themselves with much larger allocations to stocks than the target allocations in their personal investing strategies.
When the stock market started to fall, the heightened level of risk in those investors’ portfolios became apparent. With stocks falling 37 percent in 2008, even those who had thought they had conservative allocations to stocks found themselves with losses of 20 percent or more. With rebalancing, these investors wouldn’t have avoided losses entirely, but they would have reduced their impact and made it easier to recover from the market’s collapse.
Will History Repeat?
Since 2009, we’ve seen an even more dramatic move in stocks, with the S&P 500 (^GSPC) needing to rise less than 10 percent further to triple its worst levels during the bear market five years ago. That has sent stock allocations through the roof for those who haven’t rebalanced their portfolios.
Moreover, even for those who are diligent about rebalancing, 2013 has been an extreme year for portfolio balance. During much of the mid-2000s, stocks and bonds rose together, limiting potential imbalances. In 2013, though, bonds have fallen at the same time that stocks have soared, and so even in the space of a single year, a 50/50 portfolio has seen its stock allocation rise as high as 60 percent.Bing, Dow Jones Industrial Average, investing, ira, irs, money, retirement, Roth IRA, Savings, stocks, Wall Street