Rebalancing Keeps Us from Over-Indulging


Do you know that feeling of regret after you’ve eaten that seventeenth Christmas cookie in the same day? Me too. It was good in a small dose, so we tell ourselves that it must be even better in larger doses, right?

In a way, managing risk in our portfolio is similar to managing our diet during the Holiday season. We see something good in front of us, and we want more of it. If it’s good, and we like it, we want even more of it. It’s a natural response. In investing, we are often tempted by strong performing investments. If we see them outperforming other investments, we may want more. If it keeps working, we want even more.

This desire for more of what makes us feel good can “work” for awhile, but market history thoroughly documents the fact that trends change, and yesterday’s winners eventually become tomorrow’s losers. Regularly rebalancing our portfolios is a very effective way to make sure that we don’t over do our desire to load up on what
has most recently made us feel good.

Consider the simple example below that compares the performance of U.S. stocks (S&P 500) to international stocks (MSCI EAFE) from 1/1/2012 – 12/20/2012. International stocks have lagged U.S. stocks for the last few years, but that trend has turned around somewhat in the last half of 2012.

A Tale of Two Halves
U.S. stocks outperformed in the 1st half while International stocks outperformed in the 2nd half

Suppose an investor held half of a portfolio in U.S. stocks and half in international stocks at the beginning of the year. Rebalancing on June 30—the midpoint in the year—would have had that investor sell some of their U.S. stocks to buy international stocks, as U.S. markets outperformed international markets by almost 7% through the end of June. This would have brought both positions back to a 50% weighting in the portfolio.

By rebalancing, they owned more shares of international stocks, so when international markets recovered in the second half, our investor’s gains would have been larger than they would have been had they not rebalanced.

In other words, rebalancing helps investors continually buy low and sell high with small pieces of their portfolios. Also of importance is the fact that this discipline helps investors keep their portfolios aligned with the original risk tolerance that they had set up with their financial advisor.

While owning only the S&P 500 would have still produced the best returns throughout most of 2012, we know from history that this won’t always be the case. In fact, over the last decade and more, there have been numerous instances of international outperformance and domestic underperformance.

There are many “rules of thumb” that have historically proven to be of value to investors. Diversify your holdings, invest with your goals in mind, take only the needed amount of risk and rebalance periodically are a few such rules. None are guaranteed to make us rich, but they help keep our plan on track, and, like self control during the Holidays, they help keep us from over-indulging on the last
best thing.

Past performance is not indicative of future results. Current performance may be lower or higher. U.S. Stocks are Standard & Poor’s (S&P) 500 Index which is comprised of 500 large U.S. stocks. International Stocks are MSCI EAFE Index which is comprised of large stocks from developed non-U.S. countries. Price only returns are presented. Indexes are unmanaged baskets of securities that investors cannot directly invest in; they do not include advisory fees or other investment expenses.


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