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How Investment Diversification Works

The Logic of Portfolio Rebalancing

Bottom line, it's impossible to predict what the market will do from year to year. Past performance, as they say, is no indication of future success.

Think back to a year ago when you first allocated the assets in your portfolio. You chose to invest 60 percent of your portfolio to stocks because you decided it was the right amount of risk. Now, because of the way your investments performed over the past year, your portfolio contains more than 60 percent of your money in stocks. Essentially, you've increased your risk. If stocks take a nosedive next year, then you've left yourself vulnerable.

The logic of rebalancing your portfolio might seem illogical at first. After all, you're essentially selling the assets that are doing well and buying more of the assets that are doing poorly [source: The Wall Street Journal]. By restoring your assets to their original percentages, you are ensuring the same level of risk over the long term. If you didn't rebalance your portfolio, your money would blindly chase the winds of the market.

Another logic of rebalancing has to do with the central tenet of investing: Buy low and sell high. By buying more in low-performing assets, you get more for your money. For example, if you buy $1,000 of IBM stock at $1 a share, you get 1,000 shares. If you waited to buy the same stock at $10 a share, you'll only get 100 shares. By buying when stocks are low, you get more shares and therefore more potential for long-term growth.

For most investors, it's enough to rebalance once a year [source: Carther]. But you should always consider the cost of rebalancing. Buying and selling stocks and bonds requires a broker or an online trading account. Both carry fees for each trade. If your portfolio isn't terribly out of whack, you might want to wait to rebalance until it's worth the transaction fees.

If all of this talk of style charts and rebalancing is giving you a headache, you might want to consider mutual funds. We'll talk more about these diversification timesavers on the next page.