It’s a simple fact: investors abhor losses. They engage in all sorts of strategies and practices in order to avoid or minimize losses. At the same time, investors are often excitable and greedy. When a segment of the investment market goes through a prolonged upswing, they throw money at it as they chase recent returns.
Many academic studies, as well as the real world experience of honest investors who admit their own mistakes, show that these practices are often ruinous. Attempts to avert loss by a wholesale shifting of money in and out of markets usually go awry, because it is difficult to predict the right times to make such moves. Investors can also miss potential large returns when they avoid markets perceived to be risky. Chasing recent hot returns periodically backfires. The multitude of investors who in early 2000 poured money into U.S. technology stocks after a four-year bull market were soundly whipped over the next three years.
Regular portfolio rebalancing is a simple but proven way to take emotions and the need for impossible predictive powers out of the process. It requires an investor to commit to holding a specific allocation of stocks, bonds, cash and other assets and then to periodically trade among those assets in order to maintain the original balance.
Suppose an investor decides to hold 50% of his money in stocks and 50% in bonds. Then suppose the stock market rises over the next year while the bond market holds steady. Stocks will now make up more than 50% of the portfolio and bonds less than 50%. Rather than sitting still, or throwing extra money into stocks because they have gone up, the investor should sell enough stocks to reduce them to 50% of the portfolio, and reinvest the proceeds in bonds.
Such rebalancing forces the investor to sell something that has gone up and buy something that has become cheaper. It keeps the portfolio’s risk in balance with the investor’s original objectives, provides an objective standard for investment decisions, and eliminates the need for guesswork about the future of the markets.
