Individual investors can find many ways to lose money in the stock market, but the most frequent is their tendency to buy-high and sell-low. It’s human nature. We get more confident when things are going well, and we become cautious and fearful when they’re not. So we load up on stocks when the CNBC talking heads are cheerleading the latest highs in the market, and we sell when their tone leaves little doubt that Armageddon is just moments away. Sadly, this natural tendency is exacerbated by the stock market’s unfailing ability to rocket too high and plummet too low. With all due respect to the oft-repeated fallacy regarding the market’s efficiency, there’s always a bubble somewhere and the popping is getting louder and far more frequent.
There is a better way. Baron Rothschild, the 18th century British nobleman and banker, provided sage advice that still holds true: “The time to buy is when there’s blood in the streets.” Similar advice was given by one of the greatest investors of the 20th century, Sir John Templeton, whose investment strategy was guided by the principle to buy stocks and companies when they reached “the point of maximum pessimism.”
Admittedly, the average investor can’t afford to take the all-in risk of these superhero investors, but anyone can follow their lead by implementing a rules-based rebalancing program. It’s simple; it removes emotion from the decision to buy or sell, and it can permanently remove “bubble” from your investing vocabulary.
The basic concept of rebalancing is familiar to anyone who has sat through a 401(k) enrollment meeting or browsed an issue or two of any personal finance magazine. It’s a basic principle of investing, but it’s a principle that is usually ignored or misused.
The traditional approach to rebalancing is calendar-based. That means the portfolio is rebalanced back to the original allocation at predetermined times, usually annually. The problem with the calendar-year approach is that it doesn’t allow you to react to sudden changes -- and sudden opportunities -- in the market. Consider March 2009 as an example. The S&P 500 hit a low of 666 on March 9, having fallen over 25% from January 1. At that point in time investors who, on January 1, held a traditional portfolio mix of 60% equity and 40% fixed income would have found themselves with a significant overweighting in fixed income (approximately 48% vs. 52% in equity). Using an annual calendar-year approach the investor would have simply left the portfolio as-is and waited for December 31 to make changes. As a result, their under-weighting in stocks would have lessened their portfolio’s gain from the S&P 500 surge from 666 in March to over 1100 at year-end.
“Rules-based” rebalancing offers a more effective approach to managing risk and boosting return. Here’s how it works. When the portfolio allocations are initially determined, a "rebalancing threshold" is also established and rebalancing occurs whenever that threshold is hit. You can make it as simple or as complicated as you like. The simplest approach is to group similar asset classes together -- e.g., U.S. stocks, international stocks, U.S. bonds, international bonds, and specialty assets. In this example, you might have a 30% allocation to U.S. stocks and set your rebalancing thresholds at 27% and 33%. In other words, any time this asset class is over- or under-weighted by 10% or more, you’ll rebalance it back to the target. A narrower approach would identify targets for each specific asset class (e.g., large-cap U.S. stocks, emerging market bonds, real estate, and commodities). Using this approach, an original portfolio allocation of 10% to commodities might have rebalancing thresholds of 8% and 12%.
Most well-diversified portfolios have seen a lot of fluctuation in 2011 and probably have significant under-weightings in asset classes like commodities and emerging market stocks that have been brutalized over the last year. On the flip side, TIPS and precious metals are probably significantly over-weighted.
The drawback of rules-based rebalancing, outside of a tax-deferred account, is the tax implications of the buy-and-sell transactions. However, while tax implications must be considered they should never drive your investment decisions. The major benefits of rules-based rebalancing are its systematic approach and its ability to compensate for investors’ emotional tendencies to chase performance and throw in the towel just when the market hits bottom and the rebound begins. Rules-based rebalancing is not a panacea, but it will prove an effective strategy for most portfolios.
So let January 1 be the last time you re-balance based on the calendar. There’s no way to avoid bubbles in the market, but rules-based rebalancing can eliminate bubbles from your portfolio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
