It’s Tough to Sell the Winners and Buy the Laggards
When the stock market recently returned to record high levels most investors breathed a sigh of relief. They should have been selling instead.
That is not a statement on the market or its potential going forward, but rather makes the point that most investors who did a midyear portfolio review were likely to find their equity holdings had grown past their target allocations, in which case rebalancing the portfolio back to the plan makes sense.
That doesn’t make it easy to do.
The basic human instinct when an investment gamble has been paying off is to let it ride; rebalancing involves culling winners and putting the proceeds into laggards in order to follow a plan. It is particularly hard right now because the current market rally has been almost entirely in stocks, with virtually every other asset class looking ugly by comparison.
That makes rebalancing feel like a setback, rather than a step up.
In fact, because so few investors follow an allocation plan, it is no big surprise that data on fund flows consistently shows the money going to what’s hot.
“The hard part of investing isn’t coming up with a plan,” said Charles Rotblut, vice president of the American Association of Individual Investors, “it is sticking to it, especially when that means taking profits off the table and having to put that money into categories that don’t look as good.”
The problem with rebalancing is that most people see it as “bailing out on winners”—a move that easily comes with regrets, especially if the market doesn’t rotate to create new areas of strength or weakness for a while—rather than as “managing risk.”
Risk management is one of the most important things you do as an investor, and if you have a reason behind your initial allocation, then it is an opportunistic thing and a critical part of your strategy.
Here’s a simple example of how rebalancing works and why it is necessary. Say an investor has split the stock portion of his portfolio 50-50 between a broad U.S. market fund and a global market index fund that excludes U.S. stocks. Over the last three years, the broad U.S. market has gained almost 20% per annum, while the global side of the portfolio is up about 6.5% annually.
After that three-year run, the portfolio is now roughly 60-40, with the domestics holding the bigger share.
Rebalancing back to the 50-50 target allocation means selling off the hot assets and investing in the cool ones until the split is again even.
Emotionally, that is exactly the opposite of what most investors want to do; they would prefer to jettison the laggards in the portfolio and double down on the winners. That is a recipe for buying high, and then being disappointed when the market turns and the favored asset classes lose their leading status.
That is why, ideally, rebalancing is done unemotionally, based on a schedule set either by how far off-plan a portfolio gets, or by regular calendar intervals. The bigger the portfolio, the more these differences matter, creating more need to rebalance on a scheduled basis; experts note average investors with moderate portfolios can get away with rebalancing every year or two, or when the portfolio is 5 to 10% off-target.
The question for most investors is whether that means the time is now which brings risk-management back into focus.
Selling off leaders to buy laggards sounds bad, so look at it as “selling into strength and buying into weakness.” You’re getting a high price for your winners—rather than letting some future market setback eat up some of your gains—and getting a bargain on the out-of-favor assets.
That is important, even for investors who want to take advantage of market momentum.
You have to ask yourself how you will make the most money over time. Yes, you want to invest in things that are working for you at the moment, but you want to own those things according to a plan that will enable you to reach your long-term goals. At the end of the day, most people believe they will make the most money over time by buying into weakness and letting the market work, but they have a tough time putting that belief to work.