It’s been a very good year for stock investors. The Standard & Poor’s 500 Index, which serves as a proxy for the U.S. equity market , is up over 25 percent in the last 12 months and stands close to an all-time high. For those who began the year with a well-conceived investment mix of stocks, bonds and cash that matched both their goals and their ability to handle risk, it’s now likely that portfolio is out of whack and substantially more risky.
Asset allocation, the proportion of total assets that an investor devotes to stocks, bonds and cash is far and away the most important part of designing a successful portfolio. More than any other factor, it will determine the returns investors earn and the level of volatility they experience. In general, the higher the allocation to stocks the more subject the portfolio is to the wild swings of the equity markets.
While assembling the right mix of investments is important so is maintaining it. Stocks and bonds react differently to market conditions and, therefore, behave differently throughout the year. Over time, the higher-performing assets (typically stocks) will grow to occupy a larger portion of the portfolio. The result is a portfolio that may be markedly different and more risky from what the investor originally intended.
Rebalancing the portfolio back to its original target allocation is an important risk-control measure that will reduce its volatility over time and may very well serve as the anchor needed to stop investors from abandoning their investment plan in a panic during the next steep market decline. In the simplest terms, rebalancing means taking profits from those asset classes that have performed well and reinvesting the proceeds in those that have performed poorly. Here are some things to keep in mind: