Hi. My name is CJ Harrison, and thanks for tuning in to the Financial Success Academy.
You may have heard that the trick to having success in the stock market is to buy low and sell high. Sounds easy enough. And it would be if we had any clue what the markets were going to do tomorrow or the next day. We don't. You don't. And some Yahoo on TV pretending to, doesn't either. Which is why stock picking, day trading, and market timing are typically ineffective practices.
In this video, we are going to discuss how rebalancing helps us systematically buy low and sell high over time without needing to speculate what the market is going to do in the short term.
So what exactly is rebalancing? Rebalancing is systematically selling some of our winners and buying some of our losers to maintain our targeted investment allocation over time, i.e., buy low and sell high.
The next question is: Why? There are two main reasons we rebalance our portfolios. The first is to manage risk. When the portfolio falls out of the targeted allocation, you become overexposed to specific asset classes.
The second reason is to potentially boost returns. In theory, the investments that over-perform their expectations become more likely to underperform them in the future. The opposite is also anticipated for investments that underperform. They would then be expected to over-perform in the future. Research conducted on the Yale Endowment Fund attributed 1.6% of its annual returns to rebalancing. If we look at the historical returns of different asset classes, we can see their unpredictable nature. This chart demonstrates how the over or underperformance of an asset class in a given year rarely leads to the same performance in subsequent years.
Letting an asset class become over-allocated in your portfolio because it has performed well recently can subject you to larger losses if it later experiences heavy underperformance. If we look at real estate, for example, in 2019 it was one of the top performers with a return of 28.7%. The following year in 2020, it was the worst performer with a negative return of 5.1%, only to be the top performer again the next year in 2021 with a return of 41.3%. And that example by systematically rebalancing would allow one to incrementally buy low and sell high.
Now that we know what and why, the next question is when. At DecisionPoint Financial, we rebalance on two occasions. First, on an annual basis. Every fall, typically October, we rebalance all of our models. Second, whenever there is enhanced or extreme volatility. In March of 2020, when the stock market dropped significantly due to COVID, we performed an unscheduled rebalance. The rebalance was triggered because a specific asset class fell below its targeted range, allowing us to sell some of the fixed-income positions and purchase stock positions at depressed values.
Important takeaways. One, we do not need to sit in cash or the fixed account waiting for a market crash in order to buy additional investments at discounted prices. Second, having an investment process helps make systematic decisions designed to improve the overall investment experience and outcome.
We hope this has been helpful. As always, stay safe and reach out if we can be of assistance.