Is This the Right Time to Rebalance Your Portfolio?

Over the past ten years, the S&P 500 has rallied about 240%. That's great news if you're a long-term investor who buys the index's top stocks. But if you haven't sold any of those stocks, they might account for much larger percentages of your portfolio than they did a decade ago.

Most financial advisors will tell you to rebalance your portfolio at least every year by pruning the stocks that have grown too much from their original allocations. For example, if you have a stock that originally accounted for just 3% of your portfolio but now accounts for more than 10%, it might be smarter to sell some shares to bring that ratio back below 5%. Doing so would improve your diversification and reduce your exposure to the fluctuations of that single stock.

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However, some critics argue that rigidly rebalancing your portfolio every year can cause you to miss out on significant long-term gains. So, is it the right time to rebalance your portfolio?

Why rebalancing your portfolio might be a bad idea

Rebalancing your portfolio every year might seem like the prudent strategy, but it can easily backfire for three simple reasons. First, you could be "pulling the flowers and watering the weeds" by trimming your top performers to accumulate more shares of weaker stocks. Anyone who sold their Nvidia (NASDAQ: NVDA) shares over the past decade just to rebalance their portfolio will probably tell you it was a bad idea. They're probably feeling even worse if they reinvested those profits in decade-long losers like 3M or UPS.

Second, selling stocks that have appreciated significantly could trigger large capital gains taxes. Those taxes would be even higher if you had held those stocks for less than a year.

Lastly, investors who simply buy and hold their stocks often outperform investors who rebalance their portfolios. For example, a $10,000 investment evenly distributed among the Magnificent Seven stocks five years ago would be worth about $30,000 today. That same investment in the S&P 500 -- which rebalances its holdings every quarter -- would only have grown to $17,000.

Why rebalancing your portfolio might be a good idea

Rebalancing your portfolio might seem counterintuitive in a bull market, but it can also limit its downside potential in three simple ways. First, it's a disciplined, mechanical way to make investment decisions that isn't driven by emotions or headlines.

Second, that approach keeps your portfolio's risk levels aligned with your long-term goals. While a growth stock like Nvidia might seem like a brilliant long-term investment during a bull market, exposing 20%-30% to your portfolio will set you up for a steep drop if it loses its luster. As Peter Lynch once said, "Everybody in the world is a long-term investor until the market goes down." When that market crash happens, your biggest asset could become your biggest liability.

Lastly, investors usually rotate between value and growth stocks. As the macro headwinds intensify, they'll sell their growth stocks and buy cheaper defensive plays. As those headwinds wane, they'll pivot back toward high-risk growth plays and other speculative investments. Instead of trying to time those swings, it might be smarter to automatically prune and rebalance those investments whenever one of those cyclical trades gets overheated.

Is it the right time to rebalance your portfolio?

I've been invested in stocks for nearly two decades, and I've never regularly rebalanced my portfolio. I also don't plan to prune my top stocks anytime soon, even though Amazon (NASDAQ: AMZN) -- one of my top performers -- accounts for over 10% of my portfolio.

However, I'm the kind of investor who believes in letting the winners ride instead of selling them too early for the sake of diversification. If you want to take a more disciplined, less emotional approach and don't have time to weigh the pros and cons of individual stocks, then rebalancing your investments every year might be the more sensible strategy.

Leo Sun has positions in Amazon. The Motley Fool has positions in and recommends 3M, Amazon, Nvidia, and United Parcel Service. The Motley Fool has a disclosure policy.