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Portfolio Rebalancing: A Less Exhilarating But More Effective Approach to Buying Low and Selling High

If a potential investor has heard only one piece of advice on how to succeed in investing, it is likely to have been: “Buy low and sell high.”  If achieved, that would indisputably result in great investment returns.  However, more debatable is the question of how best to do it.  In prior posts, we have alluded to the temptation to engage in market timing, i.e. trying to buy when the price of a particular investment is low and sell when it is high.  For the vast majority of us, however, that strategy will fail.  Due to the interference of cognitive or emotional biases, less information than the hordes of traders on Wall Street, or a host of other reasons, a market timing strategy will generally underperform as compared with market returns over the long term.  So, what is the alternative?  Market timing’s somewhat boring and nerdy younger brother, portfolio rebalancing. 

How It Works.  Portfolio rebalancing works as follows:  An investor establishes a plan to allocate a certain proportion of her portfolio to different asset classes (e.g. investing 15 percent in U.S. large growth stock funds, 10 percent in international small stock funds, etc.).  As prices of the investments change over time, these proportions will deviate from the original plan.  Therefore, the investor establishes a rule, e.g., to check the value of these investments quarterly and make rebalancing trades when the amount in an asset class diverges by a certain percentage from the original plan.  The rebalancing trades will entail selling some shares of an investment that has performed well (since its portion of the portfolio will have grown too high) and buying additional shares of an investment that has performed poorly.  Therefore, it represents a disciplined approach to buying low and selling high.  Unlike a market timing strategy, portfolio rebalancing does not rely on your ability to guess the direction of the market, just to have faith that underperformers will rebound at some time in the future, at which point you will be rewarded for having bought when prices were low.  This is far easier to do when using passively managed mutual funds than active funds or individual stocks (that one might “fall in love with”).

Strategy in Action.  This practice involves significant discipline because our emotional response of excitement over a winning investment and fear over a losing investment would often lead us to do the exact opposite.  For example, while conducting rebalancing trades for clients in January, we sold a significant amount of shares from the DFA Real Estate fund (which had gained over 30 percent in the past year) and bought shares of the DFA International Small Company fund (which had lost over 7 percent in the past year).  While an individual investor might not have had the discipline to make these trades in their own portfolio, we made them, as a matter of course, based on the client’s investment policy.  Remarkably, the three-month period from February to April 2015 demonstrated directly the value of this disciplined approach as both funds reversed direction, with the real estate fund losing almost 7.8 percent and the international small fund gaining over 10.6 percent.  Thus, if we traded $10,000 from the DFA Real Estate fund to the DFA International Small Company fund at the end of January, that amount would have grown to $11,063 by the end of April as opposed to declining to $9,221 if we had left it in the DFA Real Estate fund. 

The Bigger Challenge.   One of the biggest challenges of implementing a rebalancing strategy is having discipline during general market declines. Think back to 2008.  If you had 60 percent of your portfolio in stock mutual funds and the market declined 40 percent, you would now have about 47 percent of your portfolio in stocks.  Would you be willing to sell some of your safe bonds, to rebalance your portfolio back to 60/40?

Portfolio rebalancing may not be as exciting as a market timing strategy, but it pays dividends in the long run.

     
 

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