It’s not often that you get a second chance after you make a mistake. But investors who found out the hard way that their stock portfolio had more risk than they thought now find themselves with that unusual opportunity.

Specifically, those who hadn’t rebalanced their investments to reflect their true risk tolerance before the coronavirus market crash are now in a position to do so without damaging their portfolios.

Returning to reality

Millions of investors had enjoyed huge gains in their investments during the 2010s. With very little volatility during the entire decade, the best-performing strategy to follow was simply to let your stock market profits ride.

Moreover, as interest rates continued to drop, many investors beefed up their allocations to dividend-paying stocks as an income-producing substitute.

That led to a huge rise in allocations to stocks. Even some risk-averse investors felt they had no good alternative to putting more money in the stock market.

As a result, many investors went years without ever rebalancing their portfolios.

That left them exposed to much larger losses when the pandemic sent stocks plunging than they would’ve been with a more reasonable asset allocation.

To be fair, much of the blame lies with unrealistic assessments of how willing you are to tolerate risk in your investments. For anyone who started investing after the financial crisis, a lack of bear markets left investors without any real understanding of what market volatility actually looks like.

It’s far easier to say theoretically that you’re willing to see 30% of your net worth disappear than it is to actually go through that experience. When they did in February and March, many investors were on the verge of panic — and it took all the discipline they could muster to avoid making a massive mistake by selling out their stocks at the lows.

How rebalancing can help

To see what rebalancing does, let’s look at an example. If you had $200,000 10 years ago and you’d invested 60% of your money in an S&P 500 index fund and 40% in a bond index fund, then you’d have seen the stock portion of your investments go up by 260% while the bond fund would’ve risen just over 45%.

That would’ve turned the $120,000 you initially put into the S&P 500 fund into $432,000, while the $80,000 in bonds would now be worth about $116,000. That allocation is very close to 80% stocks and 20% bonds — far more aggressive than the 60%/40% split you started out with.

At their worst levels, stocks fell 30% while bonds were down just 5% or so. Those who rebalanced prior to the market crash would still have seen significant losses, but the damage would’ve been limited to about 19%. Those who didn’t rebalance, however, suffered a much larger 25% decline.

A lucky break

Fortunately, it’s taken only a few short months for the stock market to regain just about all of its losses from the coronavirus bear market. As long as you didn’t take any action, that’s put you back in a situation in which rebalancing can reduce your risk level going forward back to what you’re comfortable with.

You can rebalance in a couple of ways:

  • Just sell off a portion of your investments in the high-performing asset class — in this case, stocks. Be careful, though, about the tax consequences of selling investments with a profit.
  • If you’re adding new money to invest, direct it toward the lower-performing asset class — in this case, bonds or cash, depending on your investing strategy. You won’t see an immediate shift, but gradually, your portfolio will get back into line.

Don’t blow it again

Even though the market has bounced back quickly, there’s always the chance of further volatility ahead. To protect yourself, rebalancing your portfolio is a smart thing to consider. If it’s been a while since you rebalanced, take a look at your investments today and see if it makes sense in your situation.

— Dan Caplinger

Where to Invest $99 [sponsor]
Motley Fool Stock Advisor's average stock pick is up over 350%*, beating the market by an incredible 4-1 margin. Here’s what you get if you join up with us today: Two new stock recommendations each month. A short list of Best Buys Now. Stocks we feel present the most timely buying opportunity, so you know what to focus on today. There's so much more, including a membership-fee-back guarantee. New members can join today for only $99/year.

Source: The Motley Fool