For much of the past year, I have argued in several blogs that bonds should be regarded as risky assets.  When ten-year Treasuries were yielding less than 2%, for example, I pointed out that this meant their prospective real return would almost certainly be negative.  On September 13, I warned about the potential for a liquidity crisis in the corporate bond market next time it encountered heavy selling pressure.  And “What Next?” posted on October 11, concluded that the various scenarios following Federal Reserve “tapering” of quantitative easing all favored the stock market over the bond market.

With the year-to-date total returns of the S&P 500 and the ten-year Treasury at about 30% and -7% respectively, the question of the day is:  should you now rebalance back to your target allocation by taking money from your stock portfolio and adding it to your bond portfolio?

And my unequivocal answer is, yes.

Failure to rebalance means that for some reason you now want to take on far more stock market risk than you had decided was appropriate when you developed your target allocation.

Because–make no mistake about it–the stock market is now a much riskier place than it was a year ago.  And the fact that you’re feeling mighty plump and satisfied with that 30% return should set off flashing red lights and wailing sirens.  We always feel complacent about risk when the market has paid us handsomely; and when we’ve been hammered by a bear market, we always tremble with trepidation and feel we should sell out to stop the bleeding.

So, forget what you feel.  Today’s stock market is rife with rampantly bullish sentiment.  In addition, margin debt is exceedingly high and valuations stretched.  These are all important warning signs. Forget also those year-end predictions about where the S&P 500 will be trading this time next year; all the independent, objective research into such predictions has shown them to be completely worthless.  And they divert our attention from the essential fact that we don’t know what the market is going to do.

Which is exactly why we should always rebalance back to our target allocation when our actual allocation deviates significantly from that target.

But what about bonds?  Those “risky assets”?

Having declined over 4% in the past year, the Vanguard Long-Term Tax Exempt Fund (Admiral share class), now yields 3.55%.  Not bad.

And I would include very short-term bonds and money market instruments under “bonds”.  Nothing wrong with raising some cash today to reduce your risk exposure.

In contrast to the ebullience pervading the stock market, bond market sentiment is deeply depressed.  Bond investors fear what will ensue when the Fed stops pumping $85 billion a month into the market, and they also assume that somewhere down the road rates will rise, damaging bond prices.

But remember, all the research into interest rate forecasting has shown that the pundits’ predictions are worthless.  We don’t know what interest rates are going to do.  And even if we did, the consensus forecast would already be reflected in today’s prices.

The reason we diversify our portfolios into multiple asset classes is to establish a level of risk exposure appropriate to our investment objectives.  Rebalancing is the mechanism by which we maintain that exposure.

So don’t try to second-guess the markets; don’t listen to your gut instincts; stick with your plan by rebalancing.