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By Steve Lowrie, CFA
If there is a universal investment ideal, it is this: Every investor wants to buy low and sell high. Fortunately, there is a disciplined process for doing just that. Plus, it can help you stay on track toward your personal goals, even during down markets. The process is called rebalancing.
When you create your new portfolio, it’s best if you do so according to a personalized plan that prescribes how much weight you want to give to each asset class. So much to stocks, so much to bonds … and so on. Assigning these weights is called asset allocation.
However, as markets shift around, your investments stray from their original allocations, until they’re no longer invested according to plan. When this happens, you end up taking on higher or lower market risks and expected rewards than intended.
Rebalancing shifts your assets back to their intended allocations.
A Bear Market rebalancing illustration
Imagine you have planned for a portfolio mix of 50% stocks and 50% bonds. Then a bear market comes along, in which stock prices tend to decrease and bond prices increase. Your mix may no longer be 50/50. To rebalance, you sell some of the now-overweight bonds, and use the proceeds to buy low-priced stocks. In doing so, you are not only keeping your portfolio on track toward your goals, you’re selling high (overweight holdings) and buying low (underweight holdings), all according to plan.
Striking a rebalancing balance
Rebalancing is an important portfolio management tool. But like any power tool, it should be used with care and understanding.
It’s scary to do in real time
Everyone understands the logic of buying low and selling high. But when it’s time to rebalance, your emotions make it easier said than done. When markets are down, you must sell some of your assets that have been doing okay and buy the unpopular ones. In retrospect, history has shown us this is a sensible thing to do. But at the time, it can take a brave leap of faith that our capital markets will ultimately recover and continue to grow (as they always have before).
Costs must be considered
Besides combatting your emotions, there are practical concerns. If trading were free, you could rebalance your portfolio daily. In reality, trading incurs fees and potential tax liabilities. As such, it’s best to have guidelines for when and how to cost-effectively rebalance. If you’d like to know more, we’re happy to discuss the guidelines we employ for our own rebalancing strategies.
The Rebalancing take-home
Rebalancing makes a great deal of sense once you understand how it works. It offers objective guidelines and a clear process to help you remain on course toward your personal goals in rocky markets. It ensures you are buying low and selling high along the way. These are good things.
However, rebalancing your globally diversified portfolio also requires informed management, to ensure it’s being implemented consistently and cost-effectively. An objective advisor can help prevent your emotions from interfering with your reason as you implement an efficient rebalancing plan.
Steve Lowrie holds the CFA designation and has 25 years of experience dealing with individual investors. Before creating Lowrie Financial in 2009, he worked at various Bay Street brokerage firms both as an advisor and in management. “I help investors ignore the Wall and Bay Street hype and hysteria, and focus on what’s best for themselves.” This blog originally appeared on his site on on on March 23, 2020 and is republished here with permission.
