How many times have you changed lanes to try to get ahead in traffic only to end up in a slower lane? Or, how many times have you switched to a shorter grocery checkout line and it turns out to be the slower line? If this happens to you with any degree of consistency, you would probably be lousy at timing the market as well. But then, very few people can time the market with any degree of consistency. However, for investors who have their portfolios rebalanced each year, they are, in effect, timing the market and doing it well. Let me explain.
Market Timing Doesn’t Work
We know that market timing doesn’t work for most investors. Predicting changes in the direction of the market is a coin flip, which is why investors who try to outsmart the market, end up underperforming the market.
Dalbar has proven that in its annual study, showing in 2017, for example, that the 20-year annualized return for the average equity mutual fund investor was 4.67% as compared to 8.19% for the S&P 500. That 3.52 point gap is due primarily to poor market timing decisions. And, if you happen to miss the 10 best days of the market, your return would have been cut in half. The same study found that investors moving in and out of the market failed to capture as much as 60% of the returns generated from the stock market
Then there’s the increased investment costs of shifting in and out of the market – i.e. trading costs, commissions, and taxes (on gains). The actual costs, whether it’s trying to get ahead of traffic or achieve overperformance in the market invariably exceed any possible gains
Rebalancing Does Work
While market timing is not a successful strategy for most investors, portfolio rebalancing is. As I’ve written in my book, Taking Stock, rebalancing as an investment strategy has proliferated over the last several years, due largely to the advance in computer technology. In fact, for millions of investors who invest in target-date and lifestyle funds rebalancing occurs automatically at least on an annual basis and sometimes on a quarterly basis. Many managed money programs rebalance their portfolios more frequently. In most cases, this rebalancing occurs without investors even knowing about it.
How Rebalancing Works
When the market makes a significant move in any direction, as it has over the course of the last couple of years, your asset allocation will change. For instance, if your target allocation is 60% stocks and 40% fixed income and the stock market surges 20%, your stock allocation is likely to increase and your fixed income allocation will decrease. At the end of the year, your asset allocation might be 75% stocks and 25% fixed income.
Now, you might say that’s a good thing because your portfolio is generating great returns. But what would you say if the market suddenly and drastically reverses course while you are still sitting with that 75/25 allocation? Being that far outside of your target allocation exposes you to risk you never wanted to assume.
When you rebalance your portfolio, you bring your allocation back to your target by selling the securities that have become overpriced and buying securities that have more upside potential. This should be done at least once every 12 to 15 months to prevent unwanted risk or volatility from creeping into your portfolio.
Thoughtful Rebalancing Works Even Better
While rebalancing can be an effective strategy for improving returns while reducing risk, it’s often done without much thought, especially when triggered automatically by computer algorithms or manually based on a set of criteria. It’s a global, top-down approach that doesn’t consider the strength or weaknesses of the underlying securities in the portfolio.
We recommend a more thoughtful, bottom-up approach based on an assessment of the actual investments that are owned. By combining a business performance assessment with a stock performance assessment, we are able to identify which companies have a higher ceiling and a higher floor for their stock price.
So, we ask additional questions, such as
- What is their quality—have they improved or deteriorated?
- What is their value relative to their current price?
- Would buying more now enable you to take advantage of a temporary mispricing?
These are the questions a thoughtful investor should ask rather than blindly buying or selling securities based on their price movements.
In summary, there are three key takeaways from this article:
- Market timing doesn’t work
- Regular rebalancing your portfolio does work
- Applying a bottom-up analysis to rebalancing can raise both the ceiling and the floor of your portfolio returns.
