Portfolio rebalancing is a simple yet powerful way to impose discipline on the average investor, but for too many investors it's no match for the usual biases.
The need to periodically reset allocations among asset classes is a common refrain among investing professionals. And many of them say the unwillingness to rebalance is one of the most persistent investor failings.
"The best thing you can do is get out of the way of your own investments," said Kurt Rosentreter, a financial adviser at Manulife Securities. "It requires discipline and it requires control of greed."
As a starting point, most investors have targeted asset allocations based on their investing goals, their stage of life and their risk tolerance.
As the markets move along, relative performance of their holdings will skew those allocations. Over the course of a stock bull market – such as the one now in its sixth year – equity holdings might rise above target.
A rebalancing would trim back that exposure, taking profits on some stock appreciation. But it's the selling of one's winners that makes rebalancing a disagreeable and counterintuitive bit of portfolio housekeeping for the average investor.
"Why would I sell something that's going up? Let's let it ride," Mr. Rosentreter said, summing up the flawed rationale that keeps investors beholden to their best performers.
The fear of missing out can be a powerful disincentive.
As a bull market stretches on, and the memories of the preceding correction fade, faith in equities builds, Mr. Rosentreter said. "People get greedier the longer it goes. How quickly they forget."
That tendency explains why investors tend to push more money into stocks the higher the market goes. Behaviour follows performance, said Fran Kinniry, a principal in the investment strategy group at Vanguard.
"The only time equity allocations have been higher than they are today was in the late 1990s and just before the global financial crisis," he said, citing a recent Vanguard chart showing a current stock allocation of 58 per cent, compared to 63 per cent in mid-2007 and 60 per cent just before the tech stock crash.
The converse is true on the way down. The overweighting in equities exposes investors with unbalanced portfolios to a correction, making them more likely to sell stocks as the market declines.
They buy high and sell low. It seems to be an immutable truth of the markets.
Rebalancing can go a long way to correcting that behaviour.
The decision to sell is automated, to an extent. Investors in a rising market reduce their stock allocation periodically, or after a predetermined amount of stock appreciation, limiting their risk while allowing them to remain invested in equities.
In a declining market, when emotional investors are abandoning their equity holdings, the strict rebalancer will be scooping up discount stocks.
"Think of the impact that would have had in '08," Mr. Rosentreter said. "You would have sold a lot before the crash happened, but you would have made a lot of money over the previous five years. Then, when it dropped, you would have bought all the way down and made a fortune afterward."
In today's market, meanwhile, the related challenge of selling one's winners, of course, is what then to do with the proceeds at a time when cash and bonds earn trifling returns.
"It is so hard to get people to sell something that is up 30 per cent and put it into something that has a trailing return of low single digits, if not negative," Mr. Kinniry said. But bonds and cash have a rightful place in a risk-managed portfolio.
For investors who can overcome their biases, Mr. Rosentreter said, rebalancing pushes them toward that first principle of investing that so few manage to follow – buy low, sell high.
Tim Shufelt