Market rally provides another lesson in rebalancing
Buy low, sell high. Simple. But not easy. For most individual investors (and essentially all professional investors), the timing of the market and the choice of entry and exit points is a wild ride. But there is a proven, but not very exciting way to mechanically buy low and sell high over the long term: systematic rebalancing.
Boring. But remarkably important in overcoming innate psychological barriers that tend to impair our judgment in making investment decisions. The recent bull market amid the COVID-19 pandemic served as another reminder.
Legendary investor Sir John Templeton has advised investing to the point of “maximum pessimism”. Warren Buffet, the “Oracle of Omaha”, offers: “Be afraid when others are greedy and greedy when others are afraid.” But it’s the rare bird that could be committing capital looking into the abyss of a 30% drop as COVID takes hold of the country, or raking in excess profits in Bitcoin after a 50% spike. At least, it’s hard to do it in a consistent and focused way. This is where the discipline of regular rebalancing helps do it for us.
The process begins with establishing a target mix of equity and bond investments that best suits your personal compromise between risk and desired returns over a long time horizon. We focus on these simple classes for simplicity, but your mix could include real estate, collectibles, gold, or other asset classes and the principle applies as well. The day you implement your plan, the world is in its orbit and your investments are in perfect balance. Over time, some assets perform better than others. Markets recover, stocks rise or fall, the economy explodes and collapses, time flies. In no time, your hypothetical goal of 60% stocks rose to 70% (or fell to 50%). This is where emotion and instinct can be our enemies.
A simple rebalancing scheme restores order to your portfolio by shifting money out of assets that have raced forward and redeploying more cash into laggards. Sell high, buy low.
The same principle applies more granularly to subclasses of assets like US equities versus foreign equities, large caps versus small caps, and growth versus value. The transfer of liquidity from outperformers to relative underperformers imposes discipline aimed at improving long-term returns and minimizing overall risk.
Emerging markets represent one of the most potential asset classes but also the most volatile on average. In 2017, emerging markets climbed 38%, by far the best performing asset of the year. A systematic rebalancing would have taken the earnings of emerging markets and moved to fixed income, the worst performing class. In 2018, emerging markets went from first to last with a loss of 14%, while fixed income was the best performer. Our gut might have said ‘let it roll’, but a mechanical rebalancing would have sold high and bought low.
The lesson also applies to investment styles. From 12/31/19 to 8/31/20, growth stocks outperformed value stocks by an incredible 36 percentage points as tech and other ‘stay at home’ games dominated. However, from 8/31/20 until May 2021, a sharp reversal occurred where value stocks outpaced growth by 18 percentage points. Few investors had predicted the sudden reversal, but a methodical rebalancing would have capitalized on the change.
Fortunately, the rebalancing process doesn’t have to be complex. There are two approaches to the task: regular periodic rebalancing (say twice a year) or establishing tolerance bands of a certain percentage for each asset class (maybe plus or minus 5%). The latter requires more continuous monitoring, but the good news is it doesn’t matter which method you choose. Empirical studies generally cannot discern a “better” methodology, but consistently demonstrate that any rebalancing plan produces superior returns and reduced risk over time compared to no stock at all.
If you employ an advisor, that’s part of the service. If you do it yourself, there are many tools available on your brokerage firm’s website, and many brokers now offer the service inexpensively or even for free with so-called “Robo Advisor” autopilot services. . Most decent 401 (K) plans also include routine rebalancing options.
You don’t need a crystal ball. Just a plan and the occasional course correction to stay disciplined and stay on plan.
Christopher A. Hopkins is a Chartered Financial Analyst in Chattanooga.