Sell Winners And Buy Losers – Asset Rebalancing

   

asset rebalancing simple money man

Isn’t this the craziest, most counter-intuitive investment advice you’ve ever heard??? Why would I sell a stock if it’s making me money…LOTS of money? Long ago, I used to think in this type of way, but there are many reasons why it is important to take this advice. Now I believe this is valuable advice that I learned from author Ric Edelman in his book “The Lies About Money: Why You Need to Own the Portfolio of the Future”. Actually I kind of knew it before too in the back of my head from Warren Buffet’s famous quote “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” This is basically to buy low and sell high. Of course it’s easy to understand, but hard to do like so many other things, like mastering a backhand in tennis or a hook shot in basketball.

 

Art of Rebalancing

The act of asset allocation or rebalancing, which is another term is simply selling some of your stocks that made money, and buying some more of the stocks that lost money (hoping that they will bounce back and do well). How often should you do this seemingly ridiculous exercise? According to Market Watch, it recommends every quarter. The author of this article did an experiment and found out that a portfolio which is rebalanced quarterly ends up with the highest account value: Market Watch Recommendation

 

Importance of Rebalancing

Ric Edelman stresses the importance of rebalancing. What if you set your investment strategy to have 40% in mid-cap stocks, 40% in large cap and 20% in bonds three years ago? Now in 2017, the percentage you have in mid-cap has shot up to over 60% AND your large cap went down 10%. You’re asset allocation is misaligned with your original investment strategy. Furthermore, if you don’t sell some of those winning mid-cap stocks, you won’t be able to lock in those gains.  And if you don’t buy some of those loser stocks, you may miss out on the chance of those stocks bouncing back and getting in on a cheaper price. Edelman says the main reason to do this exercise is to reduce risk. If you make a profit in the process, that’s a byproduct. I’m not saying to time the market. I’m simply illustrating the importance of rebalancing to reset to your original investment strategy. Here’s an excerpt from The Lies About Money: Why You Need to Own the Portfolio of the Future which explains it better than I can (click to expand):

 

It’s very hard to sell something that is doing well. I don’t disagree with that statement. But it’s also the responsible thing to do if you are over-allocated in a particular position. I recently had to do this for a few shares of Amazon and…..man that was a tough one. It is doing crazy good and I bought it several years ago so you can imagine.

In Edelman’s book The Lies About Money, he talks about a client of his. He suggests to this client that he should reallocate some of his earnings to adjust to his original investment plan based on new circumstances that have been presented. The client agrees that the plan makes sense. Edelman then says the tax liability for the profits as a result of the proceeds of the proposed transactions will amount to $60k to which the client is shocked! Long story short, the client decides to leave the portfolio as is. A couple of months later, his portfolios which was worth over a millions dollars has dropped to six digits because he did not reallocate his holdings just to avoid the tax liability. Edelman goes on to say that paying taxes is a good thing. You can either get profits and pay taxes or have no profits and no taxes. Rebalancing forces you to buy low and sell high and as illustrated by Forbes can result in a higher value as compared to a portfolio which has never been rebalanced at all – “25 year period, the rebalanced portfolio ended with a higher return: a $10,000 investment became $97,000 vs. $89,000 for the un-rebalanced portfolio”. Apart from this, rebalancing also forces you to revisit your portfolio, see if the fees being charged in your funds are what you expected them to be. Or maybe check if dividends are being reinvested or placed in your cash account, whichever option you selected. 

If you’re investing on a consistent basis, it’s important to rebalance your investments too on a consistent basis. Both go hand in hand. How about creating a quick checklist to make sure your portfolio is proper:

 

  1. Is my portfolio mix appropriate based on my age/expectation (i.e. 70% stocks 30% bonds)?
    1. If not steps to take:
      1. _______________
      2. _______________
  2. Are dividends being reinvested (check a couple to see if amount paid and reinvested is accurate)?
  3. Are fees what I expect them to be?

 

So do you rebalance your portfolio? If so, how often and do you have any suggestions to make the process more efficient?

 

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I use Personal Capital because (1) it’s free, (2) it tracks all of my accounts and overall net worth, (3) my account balances automatically update, (4) it shows how my investments are diversified and allocated in various sectors, and (5) can use built-in tools like “Investment Checkup” to get….wait for it…free personalized advice!

 

Simple Money Man (SMM)

10 Comments

  1. Great post SMM! We try to rebalance every 6 months or so. I know some people will say that’s not enough, but we are long term investors and try to spend most of our time researching the right opportunities. With that being said we aren’t greedy, if we have a decent gain in one of our positions we will sell some of our shares and play with the houses money. Although instead of rebalancing right away, the extra cash from the gain stays in the brokerage account until we find the next investment opportunity we like. We also set our brokerage accounts to DRIP all the securities we hold so we don’t have to worry about it. Completely agree with your point that rebalancing can increase returns, and i really like the template above. Nice work!

    • Thanks Courtney! It’s good to wait for the right opportunity and patience is important as well. Sometimes, actually for me all the time it’s tough to sell winners but I think it helps us mature and stay disciplined in our investment goals. I try to research buys wayyy in advance so I can both sleep on it for a few days and I know (or can narrow down) what to get shortly after I sell something.

  2. Re-balancing is pretty counter-intuitive, isn’t it? This is why psychology always seems to mess us up when it comes to investing. If we look at how the numbers work and see that it makes sense, then that’s what we should stick to. Thankfully most big companies will now offer to let you rebalance your portfolio automatically. That takes all the fear right out of the process.

    • Yes if you’re new, it’s great to have automatic re-balancing. My target date retirement fund does this and for now I’m ok with them doing it automatically. I respect the fact that they are professionals in the industry. In this case, I’m not ready yet to pick all my own funds for retirement and re-balance them manually. Instead, I do this activity in my brokerage account.

    • You’ll quickly be up to speed I’m sure. I wish I used all this free information on the internet when I first started. But I guess hindsight is 20/20. There are so many resources out there for every type of investment, but I just like to read and try to explain them in the simplest way possible.

  3. I usually rebalance at the 5% threshold. So whenever that threshold is met I usually do it. That was based on previous advice from Vanguard that said,

    “This paper demonstrates that the risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly, or annually.”

    I”ll have to check out the article that says to rebalance quarterly.

    • I haven’t established a threshold for myself yet. But I could tell my positions in a couple of investments were so over-weighted. Even Personal Capital was saying investing in Small Cap would be a good idea :-).

  4. Rebalancing is a great strategy something I was unsure about doing because of capital gains tax. But “taxes being a good thing” in this regard made a lot of sense and good example. Thanks for bringing more clarity to this strategy and I look to forward to applying it to my growing portfolio. “Here’s to a dream life!”

    • Yes! Dream life. It can be a reality for anyone. No one likes to pay taxes, but we got to look at the bright side of things and at the same time not pay more than we should especially since options are available for having various accounts thus further diversification.

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