We know that timing the market in order to buy stocks at low prices and sell them at high prices, on average, sucks. Market timing is a path to inferior returns and losses because no one can reliably predict the future. But what if I told you that there was a foolproof method to force yourself to buy low and sell high, juicing your returns and powering your increase in net worth?
One simple concept does this. Rebalancing your investment portfolio to maintain your desired asset allocation. Let’s take a look at why this works and how to do it.
Setting your desired asset allocation is one of the most important parts of your investment plan. In a very simplified view, your asset allocation is your desired mix of investments, based on how much risk you are willing to tolerate. Because stocks (equities) are generally understood to be higher risk but higher potential returns, equities make up the majority of the total investment portfolio for people with a high risk tolerance.
Bonds and cash are the other major financial instruments that make up a typical investment portfolio. Bonds typically (but not always) move in the opposite direction of stock prices, so having a chunk of bonds in your portfolio is a way to hedge against losses due to declines in the stock market. Bonds also have a lower expected return, on average, so the more risk you avoid with bonds in your portfolio, the more reward/return you’ll potentially miss out on when the stock market takes off.
A typical asset allocation for a young person might look like:
20% fixed income (bonds)
Because your risk tolerance is highest when you’re young and don’t need access to your retirement funds anytime soon, a common way to adjust your asset allocation is to adjust the amount of stocks downward based on your age, so something like:
(100 – age) = equities percentage
Remainder = bond percentage
At Paradox Wealth, we use a slightly more aggressive formula because we have a higher risk tolerance (don’t plan on using our retirement funds anytime soon and are willing to accept significant losses for now):
(120 – age) = equities percentage
Remainder = bond percentage
Because we’re about 35, this means that our desired asset allocation is 85% equities, 15% bonds. We round to the nearest 5 to keep it simple.
Your Asset Allocation Will Drift
So you’ve started your investment portfolio and started putting 85% of new contributions into a stock index fund, and 15% into a bond index fund. Let’s say the stock market enters a correction and loses 15% of its value. Now the distribution of your funds is (85% equities -15% decline = 72.25% equities) and (we’ll simplify and assume bonds increased by the same amount: 27.75% bonds).
This new asset allocation of 72.25% equities and 27.75% bonds has drifted away from your ideal allocation of 85% equities and 15% bonds. This is probably an extreme example, but it’s happened before. So how do you get back to your desired mix?
This means adjusting the composition of your investment portfolio to get back to your pre-specified desired split of equities and bonds. There are a couple of ways to do this. The simplest is to sell the instrument that has too much value and use the proceeds from that to buy the thing that has decreased in value. So, this would mean selling off some of your bond index fund and buying more of the stock index fund, which has decreased in value. At a time when other people are probably panic selling, you’ll be going against the grain and buying the stocks that have decreased in value. These stocks are on sale! You’re “buying low”!
The converse of this is selling your equities when they have gained a lot of value in a market run-up. Your stocks are relatively overvalued and have caused your asset allocation to drift away from your target. This could mean you now have 90% equities and 10% bonds. Since bond prices generally decrease during a bull market, these bonds are on sale! You’re “selling high” for your stocks and “buying low” for your bonds!
Many people will be buying more equities when the stock market in on the way up, but if you’re rebalancing, you’ll be swimming against the tide, selling high and laughing all the way to the bank.
Isn’t This Just Another Form of Market Timing?
Ok, you got me. It sort of is. But you don’t have to time your rebalancing to “take advantage” of market swings. Keep it simple and rebalance your portfolio at prespecified times. The Paradox Wealth family does this on Mr. PW’s birthday every year, as dictated by our Investment Policy Statement. You could do it more often if you like, or you could even let a little market timing creep into your investing and rebalance after a notable change in the stock market. Just know that you can’t predict whether that change will suddenly reverse itself or continue deepening – after all, you are trying to predict the future when you market time).
Different Triggers for Rebalancing
- When your portfolio differs from your ideal asset allocation by a prespecified percentage – i.e. +/- 5% from your desired percentage. For example, if your desired asset allocation is 80% stocks/20% bonds, rebalance when it hits 85% stocks/15% bonds or 75% stocks/25% bonds.
- When your portfolio differs from your ideal asset allocation by a prespecified dollar amount – i.e. +/- $10,000 from your desired allocation. This is less useful than the previous because it does not adjust for increasing size of your portfolio in the accumulation (still saving) phase or decreasing size of your portfolio in the withdrawal (retired and living on your savings) phase
- At a prespecified time point. I rebalance our assets every year on my birthday. This takes emotion out of the equation. It helps you avoid the feeling that you’re “selling winners” or “buying losers”. It’s possible that I’m missing out on some gains (or losses) from more frequent rebalancing, but I like to keep it simple and just do it once per year. Larry Swedroe even recommends rebalancing daily to capture all the advantages of buying low and selling high, although this is less attractive if your accounts have any transaction fees.
- Whenever you contribute to your retirement funds. Put new money into the asset class that is “down” compared to your desired allocation. No selling involved. After all, many people have their assets spread out among various accounts, some tax-advantaged, some not. Selling from these accounts may incur capital-gains taxes that you’d rather not deal with. There are online calculators to help you figure out how much to buy to put you back in line with your desired asset allocation.
The Lazy Method
Some index funds automatically rebalance for you. Target Retirement Funds do this and also follow a “glide path” of asset allocation, incrementally becoming more conservative and switching to more bonds and less stocks as you age. Other funds like LifeStrategy Funds automatically rebalance but don’t provide a glide path. These are Vanguard examples but there are other similar funds from major investment firms like Fidelity. The downside here compared to a more DIY approach to rebalancing is slightly higher cost, though we’re still talking about very low cost – 0.15% expense ratio for a Target Retirement fund compared to 0.04% and 0.05% for Admiral shares of Total Stock Market and Total Bond Market index funds, respectively. For reference, the average equity mutual fund expense ratio is 0.63%.
Whatever the method you choose to rebalance, you’ll be taking advantage of the power of buying low and selling high, and optimizing your portfolio’s returns. Not rebalancing is just leaving money on the table!
How often do you rebalance? What mechanism do you use to decide when to rebalance? Do you sell the high and buy the low, or just put in new money into your “low” assets? Leave your thoughts in the comments below.