Buy low and sell high made easy.
Buying low and selling high is hard to do. A rebalancing discipline can help.
Different Investments perform at different times, move in different directions and at different speeds. This is good for diversification but may cause a portfolio to drift away from an intended mix, which is bad. When an asset class swings too far in one direction or another, levels reach beyond or below long-term averages and can’t be justified by fundamentals (or mathematical reason). When extremes are reached there is a tendency to swing back to the longer term average. Extremes tend to regress back to the mean.
A convincing example of (a particularly) mean reversion is the US S&P 500. The long-term average is about 10%. It averaged 18% in the 1990’s but has averaged about 3% since then. What goes up must come down.
Behavioral finance says that investors make emotional decisions. Investors follow trends, buy what’s hot and avoid what’s not. For example, they chase performance – they pour money into mutual funds AFTER a good run. As a portfolio drifts out of balance, it no longer reflects the investors intended risk and return characteristics. And the more volatile markets are the more an asset mix can swing and the more emotional investor decisions become. The investor must choose: Sell winners and buy underperformers, sell losers and buy more winners, or let the portfolio drift from intended targets.
Rebalancing helps logic triumph over emotions.
Rebalancing moves money from asset classes that have done well and are now at risk of being overvalued and reinvests into asset classes that have not done well and may now be undervalued. Selling high. Buying low. This bypasses investor emotion by forcing the sell/buy decision. Rebalancing offsets investor tendency to follow trends (like buying tech stocks in 1999, say). Mathematically, rebalancing captures profits by selling high before regression to the mean and reinvests in undervalued assets before they begin to move back up toward the mean.
Further, rebalancing maintains portfolio structure by resetting back to the intended mix. (Rebalancing is an incremental reduction or increase. Not all or none). This lowers risk profile by rebalancing exposures and thus cushions a portfolio against market jolts – moderating volatility and smoothing performance. In geek speak – the investor optimizes risk adjusted returns.
The best time to rebalance is usually when the market creates an imbalance in the portfolio mix (instead of an arbitrary calendar date). And rebalancing at markets highs captures gains (rather than market lows).
Practical application today? Bonds, Oil & Gas stocks and the Loonie are all up. Banks, the US and many Global equity markets are down. Is it time to rebalance?
Originally published in the Business Thompson Okanagan news, August 2008.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Fund.