Standard everyday financial advice would be a lot easier to follow if it didn’t contradict itself so often. One basic precept tells us, “Buy low and sell high.” Then another admonishes, “Never try to time the markets.” This may explain why people get so confused about money management.
Now, I’m as puzzled by life’s paradoxes as the next guy. But I can suggest a way to wriggle out of this dilemma. To buy low and sell high without market timing, one need resort to nothing more than a simple old mechanical exercise known as portfolio rebalancing. Even a computer can do it.
Say, at the beginning of each year, an investor adds up the current market value of the various asset classes among his holdings—stocks, bonds, money markets, and so forth. Once the totals are summed, the investor matches them against the intended percentages in his asset-allocation plan.
“You should review your portfolio at least annually, and rebalance it if your allocation of stocks and bonds has drifted from your target by more than five percentage points,” says the Vanguard Group, which manages $1.1 trillion in mutual funds, in a newsletter.
If the securities markets could be timed with any reliable expectation of success, there would be no need for rebalancing—or asset allocation for that matter. You could just buy whatever was bottoming out at the moment, sell it at the next top, and continue rapidly along the Road to Riches.
As timing is very hard and fraught with risks, most careful investors adopt a diversified plan of allocating their assets. It might call for 50% in stocks—and 50% in bonds.
Suppose you put $1,00,000 into each of those funds at the start of 2006. A year later, your bond-fund stake had grown to $1,04,750 and your stock fund holding to $1,15,600.
Not too bad. Notice, though, that your asset allocation is no longer 50-50. It’s 52.5% stocks, 47.5% bonds. With a couple more years of this, the difference could get much bigger. Rebalancing now can be achieved by shifting $5,425 from the stock fund to the bond fund. Problem: In any account subject to income taxes, this will involve capital gains taxes.
To avoid this, you can leave the existing amounts in the funds, and do your rebalancing by rejigging the additional investments that you plan to make this year into each fund.
What does rebalancing accomplish? Well, it keeps the risk and reward of my investment plan where I intended it to be. It adds an element of discipline to help keep the effects of my emotions in check.
And since rebalancing always steers money away from whatever asset class has lately performed best, it’s an antidote to performance-chasing. “The No. 1 thing that has hurt investors is the tendency to chase performance,” says George Roche, who retired in December as chairman of mutual-fund manager T. Rowe Price Group Inc.
By definition, rebalancers sell high and buy low. That is not to claim that they sell at the absolute top and buy at the absolute bottom. I know this isn’t so from recent personal experience, having rebalanced a while back out of a small stock fund, only to see that fund keep performing better than the other fund into which I moved the money.
If I had made that switch as a market-timing bet, I would now have to count it a mistake. But timing wasn’t my intent. As a move to keep both risk and reward balanced in a consistent asset-allocation plan, it still makes good sense—and I won’t mess things up by trying to rectify my error with another wild guess at what the markets might do next.