Diversification and allocation are two of the most important factors in determining how your portfolio will perform and its specific risk characteristics.

I’d previously written about both these topics and touched on the point that in order to maintain your allocations, you need to rebalance from time to time. Rebalancing is extremely important yet not many people do it – perhaps because they don’t see the value, they don’t know how or they just don’t keep up with their investments.

So in this article I’d like to explain the enormous benefit rebalancing brings to the table.

The problem with any portfolio filled with stocks is the allocations change frequently because stock prices frequently change. For example, if we look at a portfolio with just two stocks, Stock A trading at $10 and Stock B at $20, and decide to invest an equal amount of money in each, then assuming we have $1,000 to invest, we will end up with 50 shares of Stock A and 25 shares of Stock B (that is, we will invest $500 in each stock).

Now fast forward a few months. Prices most likely won’t remain at $10 and $20 respectively.

Let’s say Stock A’s price increases to $12 and Stock B falls to $15. At this point our portfolio would be worth $975 (25 shares of Stock B at $15 per share plus 50 shares of Stock A at $12 per share).

However Stock A would now comprise 61.5% of our portfolio while Stock B would only make up 38.5%. Quite a difference from our initial 50% allocation in each stock.

To fix this, we could simply rebalance back to our initial allocation. So we might decide to sell $108 of Stock A (that is, 9 shares) and use the proceeds to purchase 7 shares of stock B.

After this transaction, we would now own 41 shares of Stock A, down from 50 shares, trading at $12 per share ($492) and 32 shares of Stock B, up from 25 shares, trading at $15 per share ($480). We’d also have a small cash balance left over which we didn’t use to purchase shares and we’re ignoring transaction fees for this example.

The key point, however, is we have now adjusted our portfolio back to its target allocation of 50% each of Stock A and Stock B (actually 49.2% and 48% respectively, but that’s close enough).

But why bother? Is there a good reason for doing this?

As it turns out, there are several good reasons.

First and foremost it helps reduce risk. The reason to diversify over different stocks is to control risk. You don’t want one stock disproportionately affecting your portfolio because if that stock crashes, your portfolio will crater along with it. By spreading your risk amongst multiple stocks, you insulate your portfolio from the behavior of just one stock.

So if one stock starts to overwhelm your portfolio because its performance has skyrocketed, you can keep it in check by rebalancing.

Another benefit is it automatically forces you to buy low and sell high. You’ll sell a portion of a stock that has risen in value and use the proceeds to purchase shares in a stock that has either gone down or not moved up as much.

Most investors tend to do the opposite. They buy high, because of greed, and sell low, because of fear. Rebalancing eliminates this irrational behavior by automatically buying low and selling high without you having to make a conscious decision to do so. In effect, it removes your emotions from the investing equation.

And since well-performing stocks don’t continually outperform and poor-performing stocks don’t continually underperform, it makes sense to sell a portion of the outperformer in the expectation it will revert downward to its mean and use the proceeds to purchase the underperformer with the expectation it will revert upwards to its mean value.

Although not guaranteed, following this path can potentially increase your portfolio’s overall returns.

So rebalancing can reduce risk and increase returns. It’s the closest thing to a free lunch currently available in the stock market.

There’s also an important side-benefit which I touched upon earlier. Rebalancing helps remove your emotions from the investing process. Since you’re following a pre-planned strategy, you don’t have to decide what to do. You simply take the appropriate action based on what occurs with stock prices in your portfolio.

Whether you’re investing new money or simply working with existing funds, the decision of what to buy and sell is made for you. Without rebalancing, that decision is left to you and, if you’re like the majority of investors, you’ll likely buy more of what is going up and ignore (or even sell) stocks that are underperforming.

That’s called chasing performance and it’s probably the number one reason so many investors do poorly over the long term. Following a disciplined rebalancing strategy, however, helps you avoid this behavior and keeps you on a steady course to building wealth.

Hopefully I’ve convinced you that rebalancing is a good and necessary thing. The questions then become, “How often should I rebalance?” and “How should I do it?”

Both good questions which I’ll answer in the next article, 3 Ways to Rebalance Your Stock Portfolio. See you then.