“Buy low, sell high.” Simple, right?
There are, of course, other ways to make money investing, such as steadily increasing dividends, interest payments on a bond, or taking income from a real estate investment trust. Compounding, too, is an important idea.
But everyone understands the most basic investing idea, which is to buy shares of a large company that is temporarily priced too low (as was Ford Motor during the credit crisis) or of a small company that you believe will increase sales dramatically and consistently, thus attracting buyers (basically, this was Starbucks story for many years).
Demand for shares rises and price rises along with it. High enough and you sell, then reinvest or take the income, if you need it.
So why don’t we do that? If you look at the market over the past few decades, the trend is apparent: A long, plodding build-up, a bit of frenzy at the top, then a vertiginous drop. Millions of shares change hands at the bottom, and the build-up starts over.
Paging Admiral Ackbar
Inexperienced investors soon fall into a dangerous trap. Their expectations are ratcheted up by constant TV noise about opportunities and once-in-a-lifetime riches, so the newbies dump in cash and cross their collective fingers.
It goes well for a while, and the herd buys even more (and Wall Street piles up the commissions and bonuses). But then the market turns and — screeee! crash! — the selling begins in earnest. Fear and panic leads to the opposite behavior for far too many: Having bought high, and then even higher, they wait an excruciatingly long time before finally selling far too low.
Why does this happen? Basically, when an investment rises in valueour expectations rise, too, and we “forget” to book the gains. The flood of good news — stocks just hit an all-time high! — suggests that more is to come. Nobody wants to shut off the music at the height of the party.
Once the selling starts, however, loss aversion kicks in the other way. We adjust our idea of loss down to the entry price, deciding to get out only once we pass that zero point. It’s not a loss until you actually lose, right? Yes, but you only have so many chances to book those gains until they are gone for good.
Rebalancing for Life
The solution, rebalancing, is very hard work — at first. We are not built mentally as human beings to rebalance our investments. So we don’t act until things get out hand. Then we react in panic, usually doing the opposite of our initial intentions.
Rebalancing is a straightforward decision to avoid the buy-high, sell-low trap. It’s choosing, in advance, to hold a specific percentage of your investments in a specific asset. If it rises in value, you sell off the gains.
Where does that money go? To buy investments in your portfolio that have declined or risen less. By using a rebalancing formula, you don’t have to know if large cap stocks are too expensive or too cheap right now. You only have to understand that your personal investment in that asset class has grown larger than you had planned. And, in comparison, your holdings in other asset classes have become relatively small.
Sticking to a rebalancing approach forces you, over time, to sell a portion of your gainers in order to fund purchases of your “losers.” Buy low, sell high, on autopilot.
How It Really Works
The simple example is a straightforward 60% stock, 40% bonds portfolio. (There are plenty of other asset classes to consider, but let’s keep it easy for now.)
If you start off with a $10,000 portfolio, that means you own $6,000 worth of stocks and $4,000 in bonds.
The stock market goes on a tear. In dollar terms, you figure your stock is now worth $9,000. Your bond funds are doing okay. They’re up to $4,700. That means that your total portfolio has a cash value of $13,700. Not bad.
If you decide it’s time to rebalance, the math is pretty easy. Take $13,700 and multiply by 0.6. The answer is $8,220.
You have $9,000 but need to get back to the lower number, so you sell enough shares of your stock holdings to raise $780 and buy bonds with it.
Want to check your math? If you have $4,700 in bonds and add the $780, you now own a bond position worth $5,480.
What’s 40% of $13,700? Yep, it’s $5,480. You are back to 60/40.
This is the key point: By rebalancing, you have sold at least some of your gains high. That could have been stocks or bonds (or another asset in your portfolio), it doesn’t matter. What matters is that you took action.
Winning by Giving Up
Importantly, you have stopped trying to outguess the market. There’s a lot of research that attempts to establish an ideal frequency for rebalancing. But the bottom line is that you should rebalance as infrequently as you can manage, maybe as little as quarterly or semi-annually. The reason why is to avoid unnecessary taxes and trading fees.
However, you should do it, and do it religiously. Set a plan and do not waver from it. If you are unsure of how to start, a financial advisor can help you get going on a portfolio allocation and suggest a reasonable rebalancing schedule, and he or she can be there to provide gentle discipline when necessary.