Rebalancing

The Right Way to Buy Low and Sell High

Buying low and selling high is the goal of all investors.  Unfortunately, volumes of data have proven that there is no reliable way to time the market (whether that be at the asset class, fund, or individual stock level).

It is common knowledge that different investments act…differently.   In fact, buying uncorrelated investments (i.e. investments that don’t always move in the same direction) is the key behind diversification.  The idea is that the uncorrelated investments in a single portfolio will combine to provide a more consistent and reliable stream of returns.

Part of maintaining a diversified portfolio is rebalancing.  Rebalancing is the process of trading the portfolio back to its target allocation.  Because investments move in different directions, a portfolio on day 1 will look different than on day 2.  This process compounds as time goes on, especially when markets are volatile.

To illustrate, consider a portfolio that owns $100,000 of stocks and $100,000 of bonds (a.k.a. a 50/50 stock/bond portfolio) and the following series of returns.

  • Period 1: Stocks are up 40% and bonds are flat. The portfolio is now $140,000 stocks and $100,000 bonds.  The stock/bond mix is now 58/42.  Since stocks are riskier than bonds, the portfolio now has more risk than its 50/50 starting allocation.
  • Period 2: Stocks are down 20% and bonds are up 4%. The portfolio is now $112,000 stocks and $104,000 bonds.  The stock/bond mix is now 52/48 and the portfolio returned 8% along the way.

Now, let’s consider the same series of returns but rebalance the portfolio after Period 1.

  • Period 1: Stocks are up 40% and bonds are flat. The portfolio is now $140,000 stocks and $100,000 bonds.  The stock/bond mix is now 58/42.  The portfolio is rebalanced back to its target 50/50 allocation so that there is $120,000 in stocks and $120,000 in bonds.
  • Period 2: Stocks are down 20% and bonds are up 4%. The portfolio is now $96,000 stocks and $124,800 bonds.  The portfolio has returned 10.4% and is again in need of rebalancing.

This is a simplified example but there are a few key takeaways:

  1. The average stock and bond returns over these two periods were 10% and 2%, respectively. This is fairly consistent with long-term historical returns.
  2. Rebalancing improved returns.
  3. Rebalancing reduced risk. The loss in period 2 without rebalancing was 10%.  The loss in period 2 with rebalancing was 8%.
  4. Rebalancing systematically bought low (by buying bonds at the end of period 1) and sold high (by selling stocks at the end of period 1). In other words, rebalancing provides a disciplined way to buy low and sell high relative to the investments inside the portfolio.

The capital markets and the returns they provide are unpredictable but what is certain is that volatility will always be part of the investment experience.  Proper rebalancing can use volatility to reduce risk and improve returns.

Seaside Wealth Management can help identify a proper target allocation based on your goals and maintain that allocation through a process of constant monitoring and rebalancing.  Please contact our office if you would like to learn more.