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When the stock market returned to record high levels recently after a bit of a setback, most investors breathed a sigh of relief.

They should have been selling instead.

That’s not a statement on the market or its potential going forward, but rather makes the point that most investors who did a midyear portfolio review were likely to find that their domestic-equity holdings had grown past their target allocations, meaning that rebalancing the portfolio back to the plan makes sense.

That doesn’t make it easy to do.

The basic human instinct when an investment gamble has been paying off is to let it ride; rebalancing involves culling winners and putting the proceeds into laggards in order to follow a plan.

It’s particularly hard right now because the current market rally has been almost entirely in domestic stocks, with virtually every other asset class looking ugly by comparison.

That makes rebalancing feel like a setback, rather than a step up.

In fact, because so few investors follow an allocation plan, it’s no big surprise that data on fund flows consistently shows the money going to what’s hot.

“The hard part of investing isn’t coming up with a plan,” said Charles Rotblut, vice president of the American Association of Individual Investors, “it’s sticking to it, especially when that means taking profits off the table and having to put that money into categories that don’t look as good.”

The problem with rebalancing is that most people see it as “bailing out on winners” — a move that easily comes with regrets, especially if the market doesn’t rotate to create new areas of strength or weakness for a while —— rather than as “managing risk.”

“Risk management is one of the most important things you do as an investor, and if you have a reason behind your initial allocation, then it’s an opportunistic thing and a critical part of your strategy,” said Jason Browne, chief investment officer at FundX Investment Group.

Here’s a simple example of how rebalancing works and why it’s necessary.

Say an investor has split the stock portion of their portfolio 50-50 between a broad U.S. market fund and a global market index fund that excludes domestic stocks.

Over the last three years, the broad U.S. market has gained almost 20 percent per annum, while the global side of the portfolio is up about 6.5 percent annually.

After that three-year run, the portfolio is now roughly 60-40, with the domestics holding the bigger share.

Rebalancing back to the 50-50 target allocation means selling off the hot assets and investing in the cool ones until the split is again even.

Emotionally, that’s exactly the opposite of what most investors want to do; they would prefer to jettison the laggards in the portfolio and double down on the winners. That’s a recipe for buying high, and then being disappointed when the market turns and the favored asset classes lose their leading status.

That’s why, ideally, rebalancing is done unemotionally, based on a schedule set either by how far off-plan a portfolio gets, or by regular calendar intervals.

The bigger the portfolio, the more these differences matter, creating more need to rebalance on a scheduled basis; experts note that average investors with moderate portfolios can get away with rebalancing every year or two, or when the portfolio is 5 to 10 percent off-target.

The question for most investors is whether that means the time is now.

This, again, brings risk-management back into focus.

Selling off leaders to buy laggards sounds bad, so look at it as “selling into strength and buying into weakness.” You’re getting a high price for your winners — rather than letting some future market setback eat up some of your gains — and getting a bargain on the out-of-favor assets.

That’s important, even for investors who want to take advantage of market momentum.

Browne, of FundX, follows a strategy of investing in funds and ETFs that have the hot hand, trying to ride category leaders in the areas that look best, but he noted that there’s a difference between selecting the right investments and setting the right investment strategy and allocation.

“You have to ask yourself how you will make the most money over time,” he said.

“Yes, you want to invest in things that are working for you at the moment, but you want to own those things according to a plan that will enable you to reach your long-term goals. At the end of the day, I think most people believe they will make the most money over time by buying into weakness and letting the market work, but they have a tough time putting that belief to work. … This would be one of those times to do it.”

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at or at P.O. Box 70, Cohasset,

MA 02025-0070.

Copyright, 2013, MarketWatch