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How Investment Diversification Works


Rebalancing Basics
A trader walks past monitors at the New York Stock Exchange on March 30, 2009. The Dow dropped 288 points that day on news that Chrysler and General Motors may declare bankruptcy.
A trader walks past monitors at the New York Stock Exchange on March 30, 2009. The Dow dropped 288 points that day on news that Chrysler and General Motors may declare bankruptcy.
Mario Tama/Getty Images

Car manufacturers recommend that you get your tires balanced every 5,000 miles (8,047 kilometers). The same is true for your investment portfolio. About once a year, you should rebalance your portfolio to make sure that your investment allocations are still where you want them to be.

Now you may be wondering, "If I didn't change my allocations, why would they be different?" That's because, as an investor, you only control how much money you put in to the system. The market controls how much money you actually have at any given time. If I invest $1,000 today in IBM stock, that same stock could be worth more or less money in a week, a day or even an hour.

The only way for your allocations to remain the same is for each of your assets to grow or shrink at the same rate. With so many different investments and so many different financial variables, that's not likely to happen. That's why you need to periodically rebalance your portfolio to restore your allocations to their original percentages.

Let's look at an example. When you created your portfolio a year ago, you allocated 60 percent to stocks and 40 percent to bonds. Looking at your year-end statement, your total investment portfolio grew 15 percent over the year. Congratulations! But upon closer inspection, while your stocks did great, your bonds actually limped along for a loss. The result is that more than 60 percent of your total money is now in stocks and less than 40 percent is in bonds.

Now, instinct might tell you to leave your portfolio the way it is. After all, isn't it smart to keep more money in the assets that are doing well? While that logic might make sense in the short term, it doesn't hold up in the long term.

Read more about the logic of portfolio rebalancing in the next section.


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