Rebalancing is considered a key element of buy-and-hold, to the point that buy-and-hold has become a shorthand for buy, hold, and rebalance. Investment advisor Rick Ferri made this clear in his interview with Morningstar: Buy, Hold, and Rebalance Works.
Rebalancing is also said to lead to “buy low, sell high.” The Bogleheads Wiki says:
[Rebalancing] is accomplished by transferring funds from higher-performing classes to lower-performing classes. While potentially counterintuitive, rebalancing ensures that investors “Buy Low” and “Sell High”.
Journalist Linda Stern wrote for Reuters How to force yourself to buy low and sell high:
Investors who wish they were better at buying low and selling high actually have a tool that can force them to do just that. It’s called “rebalancing” … …
Investment advisor Carl Richards wrote in New York Times How Rebalancing Takes Emotion Out of Investing:
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.
Just searching for “rebalance buy low sell high” returns many headlines like the ones I cited above.
Buy low sell high sounds good but it’s not true that rebalancing makes you do that. Not if we are talking about rebalancing at the highest level, between stocks and fixed income. Most of the time rebalancing between stocks and fixed income is more like sell high, buy higher.
Suppose you start with a portfolio well balanced between stocks and fixed income. When do you rebalance? When one does better than the other. That will put your portfolio off balance. So you rebalance by selling one and buying the other. When the tide turns, you do the opposite.
Directing new cash to the laggard can be thought of as putting new cash into the preset mix and then immediately selling assets that performed better. Other than trading cost and tax considerations, it’s the same as standard rebalancing.
Consider this hypothetical example for someone who rebalances annually at the end of the year:
You sold stocks most of the time. By year 5, you bought stocks, but only at higher prices, because although stocks did worse than fixed income that year (+10% vs +15%), they were still up. You sold at lower prices in previous years, only to buy back at higher prices when you rebalanced at the end of year 5. That’s sell high, buy higher.
Stocks were down 10% in year 9. When you rebalanced you bought at lower prices than in year 8 but the prices were still much higher than the prices you sold at in years 1 through 7. Again sell high, buy higher.
If you are still saving for retirement by making new contributions every year, most of the time you will sell stocks when you rebalance, only to buy back later at higher prices. Sell high, buy higher.
Rebalancing is still a good way to control risk, but don’t think you are buying low and selling high when you rebalance between stocks and fixed income. When the expected return on stocks is much higher than the expected return on fixed income, more likely you will sell high and buy higher.
[Photo credit: Flickr user Kyle Steed]