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You know the golden rule of investing: buy low, sell high. But putting this old axiom into practice when it comes to balancing a portfolio means summoning the courage to sell winning investments and buy others that have plunged.
After 2008’s tumultuous market, rebalancing might mean selling some government bonds and plowing the money into domestic and international stocks, real estate, and corporate bonds to bring your portfolio back to its intended asset allocation. If you had done this at the beginning of 2000, for example, you would’ve sold off growth-oriented technology stocks and bought up value stocks, bonds, and real estate. Get the picture? It really is the ultimate buy low, sell high. “Rebalancing keeps you from making horrific mistakes by staying out of things that eventually go south and taking on things that eventually go north,” says Ernie Ankrim, senior markets adviser with Russell Investments.
First Stop: Asset Allocation
It’s impossible to rebalance if you aren’t sure of the asset allocation you’re hoping to achieve in the first place. In fact, it is probably the most important investment decision an investor can make. Proper asset allocation can account for more than 90% of portfolio returns, according to the Association for Investment Management and Research.
Most people need a portfolio consisting of at least four asset classes: domestic stocks, international stock, bonds, and real estate, says Richard Ferri, founder and CEO of Portfolio Solutions L.L.C., an investment management company based in Troy, Michigan, and author of All About Asset Allocation (McGraw-Hill; $19.95). The exact mix depends on your risk tolerance and time horizon. Younger people will want to opt for a greater proportion of stocks and therefore more risk, while those nearing retirement should have a bigger weighting in bonds.
The theory behind asset allocation is that different assets respond differently to a range of market environments. Some people liken asset allocation to putting together a good basketball team. You need a varied group, who together have complementary skills.