Rebalancing Portfolios: The buy low sell high of investing
2 minute reading time
In uncertain financial times, investments can take a temporary hit in value. A non-prudent investor may have their emotions get the better of them and start selling their positions out of fear of a further permanent drop in value. One of the core assumptions in investing is that general market valuations increase over time. Therefore, assuming that your positions are well diversified, you should not assume that valuations are permanently lowered.
How do we know when to buy and sell positions then? One primary goal is to avoiding buying high and selling low. There’s a simple procedure we can follow that guarantees the opposite. That procedure is called rebalancing.
The process of rebalancing assumes that you have some fixed goal distribution of your assets. For example, let’s say you want your portfolio to consist of 80% stocks and 20% bonds. Over time as valuations fluctuate, your portfolio will fall out of balance. For example, it can be 87% stocks and 13% bonds.
There could be a couple reasons this happened. The valuation of the stock positions could’ve risen and/or the valuation of the bond positions could’ve fallen. To get the portfolio back to the 80/20 split, we can sell off some of the stock positions and/or buy some more of the bond positions. Given the circumstances that we’re rebalancing in, it means we’re likely selling the stock positions at its high and/or buying bond positions at its low.
So when should one rebalance? There’s not a hard-fast rule and it’s dependent on taxation and trading fees, but generally people either follow a schedule (1-4 times a year) or rebalance when their distribution strays by more than say 5%.