“The fault, dear investor, is not in our stars—and not in our stocks—but in ourselves…” (The Intelligent Investor by Ben Graham)
Far too often, when markets go up, we feel wealthier and are reluctant to sell. We may even add to the position and buy more at the higher price. Conversely when markets go down, we often panic and sell. The resulting behavior is the opposite of “Buy Low Sell High”. In a J.P. Morgan study, they found that the average investor performs significantly worse than simply buying and holding any asset class, largely because of this behavior.
Figure 1: Average investor performs significantly worse than simply buying and holding any asset class
It is also strange to observe that we are often unhappy when the markets go down. This doesn’t make rational sense. If the price of our favorite food or drink goes down, we are happy because a great thing has now become more affordable. The same logic applies to markets.
“Buy Low Sell High” is conceptually simple but predicting the direction of the market is anything but. Portfolio Rebalancing is a technique that allows us to “Buy Low Sell High” regardless of whether the next market move is up or down: no prediction necessary.
How does Portfolio Rebalancing work?
- We pick a static asset allocation for our portfolio. One popular simple portfolio is Jack Bogle’s 60/40 portfolio: 60% stock and 40% bond allocation.
- Several such portfolios exist, ranging from simple ones such as Ben Graham’s 50/50, to complicated ones such as Ray Dalio’s All-Weather portfolio.
- Further discussion of asset allocation is outside of the scope of this article. If you’re interested in seeing me write about asset allocation, please leave a comment.
- We execute upon this asset allocation. One simple example would be to buy 60% VTI (Total U.S. Stock Index) and 40% BND (Total U.S. Bond).
- Further discussion of VTI vs VT, or whether VWO should be in there, is also outside the scope of this article. If you’re interested in seeing me write about this, please leave a comment.
- Over time, market movements will cause the portfolio to deviate from our chosen asset allocation.
- We “rebalance” the portfolio by selling the assets that have gone up and buying the assets that have gone down to restore our original choice of asset allocation. In doing so, we are buying low and selling high.
- IMPORTANT: this only works if you stick to your original asset allocation.
Example using Bogle’s 60/40 portfolio
- Let’s say we have a starting $10,000, with $6,000 allocated to VTI and $4,000 allocated to BND.
- 6 months later, VTI has moved up 10%, and BND has moved down 3%.
- Our balance now looks like this
- $6,600 VTI
- $3,880 BND
- We now rebalance. 6600 + 3880 = $10,480.
- 10480 x 60% = $6,288 VTI
- 10480 x 40% = $4,192 BND
- So we sell $312 of VTI and buy $312 of BND to restore the asset allocation to 60/40.
- 6288 – 6600 = $-312 VTI
- 4192 – 3880 = $312 BND.
- 6 months later, VTI has moved down 9.1%, and BND has moved up 3.1%.
- Our balance is now:
- $5,716 VTI
- $4,322 BND
- We again rebalance. 5716 + 4322 = $10,038.
- 10038 x 60% = $6,023 VTI
- 10038 x 40% = $4,015 BND
- Please note that we have earned $38 dollars in gains from our initial $10,000 investment.
How often should we rebalance? It is generally advised to do so about 1 to 2 times a year. If you’re interested in seeing me write more about rebalancing frequency, please leave a comment.
Same example but without rebalancing
- Let’s say instead that we did not rebalance.
- 6000 x 110% x (100% - 9.1%) = $5,999 VTI
- 4000 x (100% - 3%) x 103.1% = $4,000 BND
- Please note that we are back to our original $10,000 investment and we have earned no gains.
Why did we earn $38 dollars in gains from the rebalancing example, versus $0 dollars when not rebalancing? Buying low and selling high of course!
Thanks all for reading!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.