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Need for Rebalancing

October 7th, 2009 at 12:51 pm

I thought I would follow up on a point I made yesterday concerning rebalancing. Everyone understands the reason for diversification and dollar cost averaging. Basically, don't put all your eggs in one basket and no one can market time.

Think of it this way. Over the past 2 years you had a top and bottom. The top occurred in October 2007 and the bottom occurred in March 2009. If you were out of the market from March 2009 to September 2009, you missed about a 37% return. If you had dollar averaged you would been buying all along the way. At the top, you would have been buying less shares in your mutual funds and the bottom you would have been buying more.

Now, I rebalance my portfolio twice a year – March and September. I could have picked once a year or and other 2 months in the year that are 6 months apart. I just like March and September.

With rebalancing, you need to have an allocation in mind. Let's say simply that you are 60% stock and 40% bond. In the above example as we approach September 2007, my allocations might be approaching 70% stocks and 30% bonds. The first thing to note is that my portfolio is riskier then my original allocation. In this case, I would sell my stock and buy bonds to get the allocation back to the original 60/40.

The second thing I am doing here is taking some profit and investing into my other asset classes. I am doing the opposite of chasing performance. I am buying into asset classes underperforming and selling the hot classes.

So, in March 2009, my portfolio might be 60% bonds and 40% stock. This portfolio is a lot more conservative then my original allocation. So, I sold the stock and bought bonds to get back to the 60/40 split. Last month, I rebalance where I sold so stocks and bought bonds because of the run up from March to September.

To illustrate my point about asset classes, I have attached the picture below. Noticed in 2002, the best performer was Lehman Agg (bond index) and the worst was Russell 2000 growth. And in 2003, Lehman Agg was the worst performer and the Russell 2000 was the best. By rebalancing in 2002, you would have been selling your Lehman Agg (your hot mutual fund) and purchasing Russell 2000.

The other great thing, much like dollar cost averaging, rebalancing on set dates takes the emotion out of your investments. It just something you do.



Source: http://www.swapmeetdave.com/Bible/Callan.htm

5 Responses to “Need for Rebalancing”

  1. creditcardfree Says:

    Very well explained!

  2. monkeymama Says:

    Rebalancing is extremely important. Asset diversification is worthless if you don't rebalance. Well, it's been very apparent the last couple of years, with such wild stock market swings.

  3. baselle Says:

    Rebalancing is important, its just a bit weird at this time because it seems like we are in an oversold stock market and a bond bubble at the same time. It used to be that stocks and bonds moved in opposite directions so it was more straightforward. Perhaps I'm over thinking it a bit.

  4. merch Says:

    I was using a simple example just to illustrate. The correlation, I believe, is more of macro issue then an asset class issue.

    I also believe the stock market is topping and seems to be having problems moving up. And I don't see any news moving it up. I only see things moving it down - mainly unemployment, dollar weakening, possiblity of future inflation, weak real estate market, option arms resetting.

    But good point, Baselle.

  5. Broken Arrow Says:

    Yeah, seem to me the market is acting very funny. I think we are in an artificially-induced liquidity bubble. Maybe it's not massive like the housing or oil bubble, but yeah, an actual bubble caused by the Fed pumping too much money into the system....

    Even for the stock market, the recent behavior isn't normal, and something has to give. But what...? Well, whatever it is, I've been acting very defensively.

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