Portfolio Rebalancing: A Less Exhilarating But More Effective Approach to Buying Low and Selling High

If a potential investor has heard only one piece of advice on how to succeed in investing, it is likely to have been: “Buy low and sell high.”  If achieved consistently, that would, of course, result in great investment returns.  However, the problem is how to do it.  For the vast majority of investors, the strategy of trying to perfectly time purchases and sales of investments will fail.  Due to the interference of cognitive or emotional biases, imperfect information about future earnings of companies, or a host of other reasons, a market timing strategy generally underperforms as compared with overall market returns over the long term.  So, what is a better alternative?  The answer is:  market timing’s somewhat boring and nerdy younger brother, Portfolio Rebalancing. 

How It Works.  Portfolio rebalancing works as follows:  An investor establishes a plan to allocate a certain proportion of her portfolio to different asset classes (e.g. investing 15 percent in U.S. large growth stocks, 10 percent in international small stocks, etc.).  As prices of the investments change over time, these proportions will deviate from the original plan.  Therefore, the investor establishes a rule:  for example, to check the value of these investments quarterly and make rebalancing trades when the amount in an asset class diverges by a certain percentage from the original plan.  The rebalancing trades will entail selling some shares of an investment that has performed well (since its portion of the portfolio will have grown too high) and buying additional shares of an investment that has performed poorly.  Therefore, it represents a disciplined approach to buying low and selling high.  

Unlike a market timing strategy, portfolio rebalancing does not rely on your ability to guess the direction of the market.  It just requires that you have faith that underperforming asset classes will rebound at some time in the future, at which point you will be rewarded for having bought when prices were low.  (Note:  it is far easier to implement this and treat your investments unemotionally when using passively managed mutual funds, rather than active funds or individual stocks to which you might become attached.)

Strategy in Action.  This practice of portfolio rebalancing involves significant discipline because our emotional response of excitement over a winning investment and fear over a losing investment would often lead us to do the exact opposite.  For example, while conducting rebalancing trades for clients in January 2021, we used cash from many clients’ year-end distributions to buy shares of the DFA Real Estate fund, which had declined 9 percent over the previous 12 months while most stock asset classes had posted gains.  An individual investor might not have had the discipline to purchase real estate in their own portfolio, but we made these trades, as a matter of course, based on the strategy of rebalancing to clients’ portfolio targets.  Remarkably, the remainder of 2021 demonstrated the value of this disciplined approach as the real estate fund reversed direction, rocketing up by over 41 percent during the calendar year. 

The Bigger Challenge.   One of the biggest challenges of implementing a rebalancing strategy is having discipline to stick with it during general market declines. Think back to 2008 or the spring of 2020.  If you had 60 percent of your portfolio in stock mutual funds and the market declined 40 percent, you then were left with about 47 percent of your portfolio in stocks.  Were you—or would you be—willing to sell some of your safe and steady bonds, to rebalance your portfolio back to 60/40?

Portfolio rebalancing may not be as exhilarating as a market timing strategy, but it pays dividends in the long run.