Most investors do not have a solid strategy for buying low and selling high. Today, in our Learn About the Stock Market Series, we are going to give you a simple strategy to buy low and sell high. This strategy is also a great stock market risk management tool. I’m talking about Rebalancing.
Rebalancing Your Portfolio: Review your account on a regular basis to move your asset positions back in line with your intended allocation.
Unless you are a seasoned investor, this could be a bit hard to grasp. This is easier to understand using examples.
Joe rolled over $100,000 in his 401k to an IRA. He decided to buy 90% stocks and 10% bonds. The stock market crashed and at the end of the year, he owns $70,000 in stocks and $12,000 in bonds. Instead of having 90% of his portfolio in stocks, he now has 85%. Joe needs to rebalance. He needs to sell some bonds and by some stocks. Notice, that stock values have decreased so he is buying low and bond values have increased so he is selling high. With $82,000 in his portfolio, Joe’s target is 90% stocks or $73,800. Joe needs to sell $3,800 in bonds and buy that much in stocks to achieve his 90-10 split.
Let’s look at another example when the stock market increases. Abby has a $1,250,000 in her 401k and will retire in 5 years. Her
portfolio asset allocation for her risk tolerance (how comfortable she is with the prospect of losing money) and time horizon (amount of time until she needs her money) is 60% stocks, 30% bonds, and 10% cash. At the end of the year, the stock market has a great year and gains 22%, bonds are down by 3%, and cash earns 1.5%. At the end of the year (see chart), Abby will have 65% in stocks, 26% in bonds, and 9% in cash. Because, Abby’s risk profile is rather conservative, having 65% in stock is too risky for her. By rebalancing her account back to the 60-30-10 position, she will sell her stocks that have been increasing (selling high), buying more bonds (buying low), and leaving more in cash.
Advantages of Rebalancing
There are two distinct advantages of rebalancing:
- Risk Management - Rebalancing is a risk management tool for your portfolio. In both of the examples above, Joe and Abby reduced their risk by rebalancing. Joe’s portfolio was out of balance and too conservative. He would not meet his retirement goals because he was too conservative in his investments. Abby, on the other hand, ended up with a portfolio that was too aggressive. She ran the risk of a bad year in the stock market taking a bigger chunk of her retirement savings than desired for her risk profile.
- Implement a Buy Low – Sell High Strategy – Rebalancing is one of the easiest ways to buy low and sell high using a disciplined approach. This does not mean that you are boosting your returns through rebalancing. A Vanguard study showed that rebalancing an account can actually diminish your returns over time. Rebalancing is a risk management tool and not a tool to increase your returns.
Disadvantages of Rebalancing
Conversely, there are two disadvantages of rebalancing.
- Increased Taxes – If you are rebalancing in a taxable account (accounts other than a retirement or 529 account), you could incur both short-term (less than a year) and long-term (more than a year) gains. Anytime you incur gains in a taxable account, you will be required to pay taxes on that money. In both of the examples above, there are no tax implications because Joe and Abby are working with retirement accounts (non-taxable).
- Increased Fees – Anytime you are buy and sell investments you typically incur fees or will pay commissions. Even if you are rebalancing, you will still pay these fees.
Rebalancing your account is a is absolutely necessary to ensure you are not taking on too much risk in your investment accounts. Done correctly, you can maintain the correct amount of risk in your account and save on fees. To get 5 Tips on Rebalancing Your Accounts, join me next week.