Why You Need to Rebalance



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Suppose you invested $100,000 on January 1st, 1995. You invested $50,000 in the Barclays U.S. Aggregate Bond Index and $50,000 in the S&P 500 (U.S. stocks). Between January 1st, 1995 and December 31st, 2002, you were in for quite a ride as the Dotcom Bubble expanded and eventually popped. Your bonds would have offered annual returns of 18.46%, 3.64%, 9.64%, 8.70%, -0.82%, 11.63%, 8.43%, and 10.26%. Your stocks would have offered annual returns of 37.58%, 22.96%, 33.36%, 28.58%, 21.04%, -9.11%, -11.89%, and -22.10%. Declining interest rates and the mania surrounding Internet-based companies fueled some really good returns during that period. In fact, if you didn’t touch your $100,000 portfolio at all during that period, I’d estimate you would have had around $206,000 by the end of 2002.

Do you notice how the last three years of S&P 500 returns from 2000 – 2002 were negative as the bubble popped and a recession began? Wouldn’t it have been nice to have liquidated your portfolio on December 31, 1999 and missed the stock market pullback? If you had, your portfolio would have been around $248,000 on December 31, 1999; $42,000 better than it would have been worth three years later!

By now I hope you know me well enough to know I’m not the type to ever advise you going all in or all out of the market. When it comes to market timing like that, I’m just not that smart, and I don’t think anyone else is, either. I believe in calculated tactical adjustments to a portfolio if you see a medium to long-term trend, but I do not believe in ultra-short-term trading and all-in / all-out investing. There's just too much uncertainty!

Some of you that were investing back in the late 1990s and early 2000s may be able to remember how hard it would have been to sell out of your high-flying stock portfolio on December 31, 1999. That was a time (like many times before) where the sky felt like the limit.

Great, Tom. You’ve told me this story about how I would have been better off selling my January 1st, 1995 portfolio on December 31st, 1999 versus holding it until December 31st, 2002, but then you told me no one can know exactly what the future holds and not to invest all-in or all-out. What can I do? You can rebalance.

Rebalancing your portfolio is something you should periodically do to bring your portfolio strategy back in line with your initial investment strategy. Sure, it can be a hassle, it can generate some capital gains taxes, and it can generate some trading fees, but oftentimes, it’s worth it. Hopping back to our 50% bonds and 50% stocks January 1st, 1995 portfolio example, did you know that by December 31st, 1999 your portfolio would have only had 29% bonds and would have swelled to 71% stocks? Would you be happy if the portfolio strategy you agreed to in 1995 drifted that much? I don’t know many investors who would be pleased with a divergence from their investment strategy of that magnitude. That’s why in the spirit of trying to more closely maintain your investment strategy and hedge your bets on the markets continuing to roar upward vs. correct downward, periodically rebalancing your portfolio is the way to go. Excluding taxes and fees, if you would have rebalanced your January 1st, 1995 portfolio at the end of every year back to a 50% bonds and 50% stocks portfolio, your portfolio would have had around $216,000 by then end of 2002; $10,000 better than if you had done nothing at all. Rebalancing your portfolio can generate taxes and transaction costs, but it also, and more importantly, allows you to not drift too far from your investment strategy. Rebalancing is a prudent way to hedge your bets on the market going up or down in the future.

I don’t often trade a portfolio, but when I do, I prefer to rebalance. Does that make me the most interesting wealth advisor in the world?

-Tom

A Variation on Buying Low and Selling High

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There are a lot of people out there who will tell you that the key to success in the stock market is buying low and selling high. From a strictly value investing strategy standpoint, I tend to agree. From an overall investment strategy standpoint, however, College GameDay’s Lee Corso comes to mind; "Not so fast my friend!"

The reason I’m a little cautious to blindly endorse buying low and selling high is because it can teeter right on the brink of an evil term called market timing. I say evil because market timing is often what gets investors in trouble when they repeatedly or completely buy into and sell out of the stock market. The problem with someone trying to time the market is that they are assuming that they know what direction the market is going in the short term, and, to be honest, I haven’t met many people who do. To make matters worse, if someone is going to buy low and sell high successfully and not leave any possible gains on the table, they will need to successfully time the market twice. Twice because they will need to know when a particular stock has gone as low as it is going to so they can buy it, and again when that same stock has hit its near-term peak so they can sell it. If a market timer is wrong, they can miss out on income and market movement, but they are also punished by incurring unnecessary transaction fees, expenses, and possibly taxes. Please believe me when I tell you that correct market timing is really hard once; it’s darn near impossible twice!

As I alluded to earlier, I really do like the idea of buying low and selling high, but within reason. So instead of making one-way, all-or-nothing bets that can be largely influenced by chance, I would propose you consider two, subtle but profound variations:

1. Stay invested and just periodically rebalance your investments by selling parts of your “winners” and reallocating the proceeds to other areas to bring your portfolio back in line with your long-term investment strategy.
2. Go ahead and try to time your withdrawals and deposits as best you can. In essence, deposit when the market is low and withdraw when the market is high.

Some of you may disagree with my tips, and that’s fine. There are times when there are tactical opportunities when it may make sense to totally enter and exit particular stocks, industries, and asset classes, but I believe that is more of an exception than a rule. I personally find comfort in thinking that I have about 60 – 70 years left in this crazy world, and I expect the stock market will be higher then, than it is now. Something about these historical stock market charts just gives me comfort…

 

A lot of investment managers I’m familiar with make money by buying low and selling high, but they do it by trimming their exposure as their holdings have gone up, not by timing the market. A lot of investors I know have made good financial decisions by sticking with their long-term, prudently diversified investment strategies and periodically rebalancing, not by timing the market.

 

Don’t try to time the market. Try to make your deposits and take your withdrawals strategically.

 

-Tom