Many investors look to set up their portfolios and then forget about them. But that can leave you exposed to greater risk than you expect, often at the worst possible time.

To avoid this risk, rebalancing is a vital part of your investment planning process. It’s just as important as choosing the right asset allocation model or picking your investments, and absolutely must be done for three key reasons.

1. Keeps your risk tolerances in line with your objectives

When the stock market does well, your investments become more aggressive and if it then crashes, you could lose big. In a long-running bull market, a portfolio that is invested 50% in large-cap stocks and 50% in investment-grade bonds might grow to 70% stocks and 30% bonds. In 2008, stocks lost 37% of their value, and bonds gained 5.2%. If you’d owned this 70% stock and 30% bond allocation, your portfolio would’ve fallen by 27.5%. If you’d rebalanced prior to 2008 to preserve your 50% stock and 50% bond portfolio, your accounts would’ve lost only 21.1%.

Conversely, when stocks perform poorly, your portfolio becomes more conservatively allocated. If you don’t rebalance, you could miss out on gains as a result. In 2009, stocks regained 26.5% of their value, and bonds earned 5.9%. If your 50% stock and 50% bond portfolio shrank to 30% stocks, your portfolio would’ve grown by 12.1% during this rally. But someone who rebalanced at the beginning of 2009 to a 50% stocks and 50% bond allocation would’ve earned a higher 16.2% return.

You can earn the better return in both cases by rebalancing your portfolio when your allocations have shifted significantly from your target. You can choose a percentage that will line up with your risk tolerances and objectives. If you plan on using your money within a few years, maybe you won’t let your accounts shift more than 5 percentage points. If you aren’t planning on using your money for another 10 years, you may feel more comfortable with letting them shift 10 percentage points before rebalancing.

2. Forces you to sell high and buy low

In theory, you know that buying low and selling high is an investment strategy you should use. Investing can get very emotional, though, and those emotions are at their height when the markets are performing either incredibly well or poorly. Instead, your instincts tell you that you must buy more of whatever is doing well and sell everything that’s tanking.

As normal as these feelings are, there is a reason that following them isn’t in your best interest. It is common that an asset class does well one year and a lot worse in the following year.

In 2017, emerging markets went from the best performing asset class with a return of 37.8% to the worst-performing asset class in 2018, losing 14.3%.

A similar shift happened from 2007 to 2008 with emerging markets and international stocks.

The opposite can also happen, and an asset class that performed badly falls back in favor. From 2015 to 2016, small caps stocks went from one of the worst-performing stocks to one of the best, and large-cap stocks recovered from a 4.4% loss in 2018 and gained 31.5% in 2019.

Rebalancing your portfolio once or twice a year ensures you’re positioned well for market corrections. You end up going against your instincts and selling the investments that have done well while buying the underperforming asset classes.

3. Ensures that you’re regularly reviewing your portfolio

You may find that your investments take a backseat to things that require your daily focus. This is especially true if you own passively managed funds. You can go years without reviewing your portfolio and making necessary changes when you own these low maintenance investments.

Portfolio reviews are a great time for making sure that your objectives haven’t changed. Have you had an important life event like the birth of a child that would change the way you invest? Are you nearing retirement and thinking about reducing your stock exposure?

The closer you are to your goal or the more changes that have occurred in your life, the more impactful reviewing and potentially making changes is. Making a plan to rebalance your portfolio at an annual review each year will help ensure that you factor important life events into your investment decisions.

Setting up your investment portfolio is extremely important to your success, but if you don’t maintain your portfolio by rebalancing, you may undo all of your initial hard work. There is no perfect formula for how often you should rebalance your portfolio — it is specific to you. But no matter how often you choose, making the commitment will help you better meet your investment goals.

— Diane Mtetwa

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Source: The Motley Fool