A Life of (Re)balance
If you had one hour of free time, would you rather:
1. Wash your windows
Or
2. Rebalance your portfolio
According to a study of 1,000 investors, conducted for AllianceBernstein and highlighted in the New York Daily News (November 2, 2005), more than 50% of investors would rather do house work than clean their financial house.
What does this study say about investors?
I think it says two things:
1) Investors are human and would rather deal with pressing life matters.
2) Rebalancing is a concept that is not understood and filled with emotion.
Investors are human
Life today is always on the go; free time is at a premium, and the last thing on our mind when we encounter an hour of free time is “Do I need to rebalance my investments?”. Cleaning our windows or doing house work is not high on our list, but the reminder of not doing house work is clear and definable. The cost of not doing chores is the discomfort of a messy house. The reminder to, or cost of not, rebalancing is not so readily apparent.
Rebalancing our investments? What does that mean? Where is the reminder? What is the cost?
A messy house is annoying, embarrassing and unavoidable; the sight of the mess provides a constant reminder to remedy the situation. Usually the reminder to remedy an unbalanced portfolio only occurs when the out-of-balance asset begins to fall in price and take the portfolio value along for the ride.
The Importance of (Re)balance
Rebalancing a portfolio is a simple concept. Rebalancing consists of selling assets that have increased and buying assets that have decreased until the percentage of each asset is equal to the original portfolio.
Example:
Original portfolio After time Rebalance Portfolio rebalanced
Asset A equals 60% Asset A equals 80% Sell 20% asset A Asset A equals 60%
Asset B equals 40% Asset B equals 20% Buy 20% asset B Asset B equals 40%
For a portfolio to become unbalanced, certain assets must increase more than other assets have decreased. This unbalanced situation means that a small group of assets represent more of the overall portfolio, making the return of the portfolio dependent upon the success or failure of these assets.
Why is rebalancing so important?
There are several reasons why rebalancing is important.
1) Rebalancing forces an old Wall Street adage: “Buy Low and Sell High”
This is exactly what rebalancing achieves. Assets that have increased in value will represent a larger percentage of the portfolio, thus the asset is sold until the percentage is lowered back to the originally targeted level of the portfolio. The selling of these assets forces the investor to take gains in the portfolio (selling high).
The proceeds that are generated from the sale are then placed in assets that have decreased in value, lifting the percentages of these assets toward the original level of the portfolio. Buying more of these assets forces the investor to reinvest in assets that have lost value (buying low).
After rebalancing, the portfolio percentages are equal to the level stated when the portfolio was constructed. This proves to be a very difficult task for emotional beings.
Simply stated, rebalancing requires that we sell the assets that are increasing in value and making money, and buy the assets that are losing money. People have a tendency to get emotional about investments by growing attached to successful investments, wanting to continue to ride them as long as they are going up, fearing that if they are sold they will “miss out” on continued growth. Losing investments are embarrassing, not making money, and forcibly forgotten from the consciousness in favor of our “winning” investment assets.
A problem arises when failing to rebalance. The successful investments begin to dominate the holdings of the portfolio, meaning that the returns of the portfolio become more dependent on success or failure of a smaller number of investments. If not rebalanced, when the successful investments reverse course, the portfolio loses twice. The investments dominating the portfolio are generating losses, and the investments that are now experiencing gains represent a smaller proportion of the portfolio than originally intended.
2) Not rebalancing has a cost that is not immediately seen
Rebalancing not only forces the investor to buy low and sell high, but research has proven that rebalancing increases overall return of the portfolio. The impact can mean as much as 1% of additional return per year. Over an investment lifetime, that one percent can make the difference between living the life you imagine and simply living life.
3) A portfolio with rebalancing provides a course of action
In order for rebalancing to work, there must be a course of action, a plan. This plan outlines what the percentages are for each investment and when to take action. All of this is decided before investments are made and emotions attempt to sway our judgment. This helps keep emotion out of investing and deal with the uncertainty of market movements.
Selling investments that are increasing and buying investments that are dropping may mean that you do not capture all of the potential gains possible, but you also do not absorb the full impact of losses or down markets. Rebalancing has the potential to smooth out your returns.
You can rebalance and clean
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