Ric Edelman: Now that you understand diversification, I am going to tell you the final step to achieving your financial goals. The one of the vast majority of investors ignore rebalancing.
When most people think of long-term investing, they think of buy and hold, but the real secret is buy and rebalance. Let me explain using a hypothetical example.
Let's say you've got a portfolio divided evenly between stocks, bonds, cash, and government securities. Over time one of these asset classes will inevitably outperform the others. Let's assume that it's the stocks that do that.
As you can see, the stocks now represent a larger portion of our portfolio than before. Our portfolio is no longer balanced the way it once was, we must fix this problem or otherwise we will end up with a portfolio that's mostly stocks and it won't be diversified based on the design we created based on our needs.
So how do we rebalance? We do it by selling some stock and buying some of the asset class that has fallen in value, in this case the cash.
Wait a minute, you might say though. We are selling the asset class that made the most money, we are buying the asset class that made the least money, it sounds crazy but it's actually the right thing to do. All you are doing or buying assets that are low in price and selling assets that are high in price. Buying low, selling high makes sense, doesn't it?
So be sure to rebalance. You will reduce your portfolio's volatility, you will reduce your investment risks, and in the process you will likely improve your investment returns.