Originally Published in the North Bay Business Journal The science of investing continues to create practical solutions that simultaneously enhance returns and reduce risk.
How to Buy Low and Sell High? Rebalancing
Rebalancing translates into bringing your portfolio back into alignment with your investment goals. Keeping your risk/return ratios on track is a crucial part managing your portfolio, and rebalancing has also been shown to improve portfolio returns. Rebalancing has been a topic of discussion and debate among academics and portfolio theorists for decades. But in the end, the payoff is easy to understand; rebalancing delivers the most essential investing payoff of all: buy low and sell high.
Asset Allocation
The fundamental goal of asset allocation is to reduce the risk that you’ll lose money—think of it as a second dimension of diversification. This is accomplished by mixing together a variety of investment vehicles whose distribution of returns are different, or poorly correlated with each other. In practical terms, that means that often when stocks are up bonds are down and vice versa. Market conditions that cause one asset category to do well often cause another asset category to have average or poor relative returns. Another key goal of asset allocation is to provide you with a smoother ride—enhancing your investing experience. If one of your asset category’s investment returns falls, you’ll be in a position to counteract your losses with better investment returns in another asset category. Although it may seem counterintuitive, the addition of lower returning assets, like cash and bonds, in your portfolio can still give a portfolio characteristics to achieve equity-like returns over time and do so with less volatility overall. An asset allocation strategy that lacks rebalancing is likely to have dramatically different risk exposure over time. In order to control the risks of portfolio drift, e.g. having too much or too little in stocks, investors typically implement a rebalancing strategy into their investment policy.
Modern Portfolio Theory
Academics and professional investors have known for years that the systematic rebalancing of portfolios provides critical risk controls. Early adopters of Modern Portfolio Theory (MPT) quickly found that their carefully wrought asset allocation schemes required monitoring and periodic adjustments to keep their portfolios true to their original intent. Since annual return and volatility expectations are the fundamental drivers of asset allocation models, it has been a common practice for decades for some managers to adjust their portfolios once per year, bringing the weightings of stocks, bonds and cash back to their original balance. It seems obvious that some type of portfolio rebalancing is essential to the maintenance of a strategic asset allocation. The important questions become how and when. The answer to these questions differs among investment managers, which leads to results that vary widely. Some professional managers use sophisticated trading and rebalancing strategies based upon market volatility and not simply the passage of time.
Historic Examples
A thoughtful rebalancing strategy significantly helped investors returns during this volatile decade. Rebalancing captured buy-low/sell-high opportunities associated with events like the technology bubble, the terrorist attacks in September 2001, the 2003 – 2007 bull market, the financial crisis, and our current global stock market rally. Rebalancing, if pursued with discipline and without emotion, is one of the best ways to systematically reinforce the practice of buying low and selling high, especially in turbulent times. Rebalancing works best when volatility is high but execution is emotionally difficult without a disciplined strategy in place ahead of time. As we all saw in 2008 and early 2009, it was especially hard to maintain discipline in a time of chaos. For investors with a long-term time horizon, a well executed plan can help manage the short-term uncertainty of global stock markets. Please do not mistake rebalancing with fundamental adjustments to your asset allocation formula. As your tolerance for risk, your situation or your goals change you need to develop a new strategies to reflect these changes.
