The stock market moved lower again on Friday, finishing another losing week for the S&P 500 (SNPINDEX:^GSPC) and other major market benchmarks. Bucking the recent trend, the Nasdaq Composite (NASDAQINDEX:^IXIC) suffered bigger losses on a percentage basis than the Dow Jones Industrial Average (DJINDICES:^DJI), and none of the indexes recovered too much from their lows of the day.
|
Index |
Percentage Change |
Point Change |
|---|---|---|
|
Dow |
(0.48%) |
(166) |
|
S&P 500 |
(0.91%) |
(41) |
|
Nasdaq |
(0.91%) |
(138) |
Data source: Yahoo! Finance.
With stocks going through a bit of a slump, some investors are getting nervous that the bull market might be coming to an end. However, the idea of selling out of the stock market entirely simply because of a gut feeling about market timing is a bad one. Too often, those gut feelings turn out to be dead wrong, and it can leave you missing out on big additional gains.
However, there is a reasonable argument for selling off a small piece of your stock portfolio. In fact, doing so is a regular feature of smart portfolio management, and not doing it can actually add risk beyond what's ideal for your long-term investing goals.
Image source: Getty Images.
Time to rebalance
Many investors use asset allocation strategies to determine how much risk they want to take and how big they want their returns to be. In general, stocks have generated better long-term returns than alternatives like bonds and cash, but those income-generating investments can also deliver less volatile returns than their stock counterparts. Therefore, choosing a percentage target for stocks, bonds, and cash is a popular way to structure an investment portfolio.
However, when you have a long bull market like what we've seen since March 2020, it can throw your allocations out of whack. For instance, say that you were targeting an allocation of 50% stocks, 30% intermediate-term bonds, and 20% cash. You took advantage of the drop in stocks a year and a half ago to rebalance, buying stocks at cheap prices.
Since then, stocks have climbed almost 90%, while intermediate-term bonds have lost 2%. Your cash position will have earned rock-bottom interest rates of around 1% for the 18-month period.
As a result of those price changes, if you did nothing with your investments, you'd now have a much more stock-heavy portfolio. Stocks would make up fully two-thirds of your assets, with bonds underweight at 20% and cash down to 14%.
Why rebalancing is smart
In order to rebalance your portfolio, what you'd need to do is trim your stock positions to get back to your 50% target. That would involve selling just under a quarter of your holdings, and then using the proceeds to boost your bond and cash positions by roughly half.
If you don't rebalance, what you're implicitly doing is accepting the higher level of risk that's involved with a portfolio that's roughly 66% stocks, 20% bonds, and 14% cash. Sure, you have higher return potential if the bull market continues. But what often happens is that people don't even realize they're overextended on the risk scale until a correction or bear market comes. That's what happened in early 2020, and many investors were appalled to see more of their gains disappear than they had expected.
Be smart with your money
It's tempting in a bull market not to rebalance, as it can feel like you're playing with house money and don't need to reduce your risk. However, a prudent rebalancing strategy can dramatically improve your returns over the course of your lifetime -- and there's never been a better time to do it.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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