How Rebalancing Takes Emotion Out of Investing - NYTimes.com

Carl Richards is a certified financial planner in Park City, Utah. His sketches are archived here on the Bucks blog and on his personal Web site, BehaviorGap.com.

The idea behind rebalancing is that you periodically reset your portfolio back to the original split between stocks, bonds and other investments.

Most people seem to follow two rebalancing philosophies: do it according to the calendar, say once a year, or do it when you reach a certain trigger point, when one portion of your portfolio grows or shrinks outside of a predetermined range.

Here?s an example of how rebalancing might work:

Let?s say you sat down in 2006 and decided that based on your goals, the right portfolio for you was 50 percent in stocks and 50 percent in bonds (high quality, short-term bonds). As part of that process, let?s also assume that you committed to rebalancing your portfolio back to that original 50/50 allocation whenever your portfolio balance strayed too far from it.

At 50/50, your portfolio allocation represented the amount of risk that you felt you needed in order to achieve the return necessary to achieve your long-term goals. Thirty percent in stocks would be too little to meet your goals, but 70 percent in stocks represented more risk than you felt you could take.

Fast forward a few years to the meltdown of 2008-9. If you went into 2008 with 50 percent of your money in stocks and 50 percent in bonds, then as the market dropped, the composition of your portfolio would have changed from the original 50/50 allocation to something different. We?ll also assume that nothing else in your life changed and your goals remained the same. The only thing that changed was the market.

For our example, let?s assume that you?re using a trigger point to rebalance. Since it?s pretty common to rebalance when your portfolio allocation strays more than five percentage points off of your target, when the market fell in 2008 you would have rebalanced when your portfolio hit 55 percent bonds an 45 percent stocks. That would have meant selling bonds to buy more stocks.

Rebalancing is not a scientific way to time the market, nor is it a magic bullet to increase your returns. It is true that disciplined rebalancing could result in slightly higher returns, but it could also lead to slightly lower returns depending on what the market does. Rebalancing also does not automatically decrease your investment risk, but again, depending on market conditions, it may slightly increase or slightly decrease your risk over shorter periods of time.

While there is plenty of debate about how to rebalance and the pros and cons of rebalancing, there is one clear benefit to employing a disciplined rebalancing strategy: it prevents you from making the classic behavioral mistake of buying high and selling low. Warren Buffett has said that the key to investment success is to be greedy when everyone else is fearful and fearful when everyone else is greedy. As we all know that is super hard to do.

It was really hard to buy in March 2009. It was also hard to get yourself to sell in December 1999 or October 2007. But if you had committed to rebalance that is exactly what you would have done. Not because you were a market whiz, and not because you knew what the market was going to do. Instead you rebalanced because it made sense to stick with your plan. Rebalancing is the only way I know of to give yourself the highest likelihood of buying low and selling high in a disciplined, unemotional way.

Rebalancing reminds me a bit of the simple checklists used by doctors. I remember going in for a routine surgery that was going to be done on the left side of my body. When I went in for surgery, I met with the doctor who knew exactly what side of my body she was operating on, but as part of her checklist, she asked me again during pre-op. After she left, no fewer than four different people came in with my chart and asked me which side they were operating on.

Each time I answered the left side, but I became increasingly curious about why they were asking me so many times. Then, as I was on the operating table and before I was put under, the doctor who I had just seen the day before asked me which side she was operating on and then handed me a Sharpie and asked me to mark the side.

When I saw her a few days later as part of my post-op visit, I asked her why they had followed such a procedure. She told me that it was a simple checklist to keep them from doing something really stupid, like operating on the wrong side. It took them an extra minute or two and a Sharpie to avoid what would obviously be a huge mistake.

And that?s the real magic of of rebalancing; it becomes our investment Sharpie.

Source: http://bucks.blogs.nytimes.com/2011/09/13/how-rebalancing-takes-emotion-out-of-investing/

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