The magical benefits of rebalancing
Suppose one of your investments shoots 40% higher.
What are the chances of it doing so again soon?
Not impossible, of course! But also unlikely.
Too often investors experience exciting results, only to undo all the good work by giving back most or all of their paper profits.
As Benoit Mandelbrot said in The (Mis)Behaviour of Markets:
‘Take a profit’.
Rebalancing: a stylised example
For the sake of simplicity, let’s say you have $100,000 and decide to begin with a 50/50 allocation to stocks ($50,000) and cash ($50,000).
We wouldn’t recommend it, but suppose you make a dreadful mistake and decide to invest immediately before stocks crash 50%, dropping your portfolio down to $75,000.
To rebalance back to a 50/50 allocation you take $12,500 from your cash to buy more stocks, so that you have $37,500 in each pile.
And then the stock market bounces, rising by 100% back to where it started.
Although the stock market has taken a round trip to nowhere, you have a portfolio of $112,500 and a profit of $12,500, while the buy & hold investor still has $100,000 before accounting for dividends and inflation.
Of course, this is an unrealistic and stylised example – and when stock markets are cheap you may well want to be more than 50% invested – but this oversimplified example shows how rebalancing can help you both to manage exposure/risk and capitalise on great buying opportunities.
What a Turkey!
Let’s take a look at Turkey, a volatile emerging market that’s delivered handsome pickings for us in the past.
ETF returns range from a tremendous 126% in 2003 (dinner party bragging rights!) to a gut-wrenching 62% loss in 2008 (the sort of year where greedy investors undo all of their previous good work).
Rebalancing helps you to limit the destruction that years such as 2008 can do to your portfolio (in fact one of our timeless investment principles concerns macro valuations/mean reversion, ensuring that we’re not exposed to such expensive markets, though that’s not the point we’re making in this post).
Importantly, practising rebalancing also means you pocketed some of the handsome returns from the preceding years of 126%, 42%, 57%, and 75%.
It also means that you have cash available to invest after the crash, so you almost doubled your money again on the rebound in 2009, when the market surged 99% higher.
Source: Novel Investor
This example is not just hindsight bias and cherry-picking figures; it’s making an important point.
Because of the interplay between momentum and mean reversion, you must take profits off the table at the highs and put them back in at the lows, both to manage risk and to maximise returns through the cycle.
It’s always tempting to hold onto winning investments for longer, but this risks giving back all those hard-earned gains.
And always remember the detrimental impact of negative numbers on compound returns: a 25% gain is completely erased by a 20% loss.
So, take a profit!
Professionals rebalance their portfolios to manage risk, and you can too, either on a percentage basis or on a time basis.
Rebalancing systematically on a calendar basis may be easier, as it’s often psychologically hard to sell winners due to the inevitable bragging rights attached.
You can rebalance your portfolio weekly, monthly, quarterly, or annually if you wish, and this simple practice can force you to buy low and sell high.
Remember the famous quote from Bernard Baruch:
‘I made my money by selling too soon’.
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