Chapter 24
The Rebalancing Strategy

Who's in charge, you or your investments?

You know not to believe in buy-hold. You understand the importance of a sell strategy. You know your magic number. But that's not quite enough. You need to be in charge of your investments—don't let your investments tell you what to do. You can't just make a bunch of investments, come back 10 years later, and expect something good to have happened. You need to be a proactive investor. You need to be the boss.

It's easier than you think to slide into reactive mode. Let's take an example shown in Figure 24.1: Let's say that you've analyzed your needs, done all the calculations, and decided that a 50/50 portfolio—50 percent stocks and 50 percent bonds—has the appropriate amount of risk for you. You've decided to invest $200, so you have $100 in stocks and $100 in bonds.

Figure 24.1 Invest $200 in a 50/50 portfolio.

You're cruising along and your stocks go up 60 percent. Holy cow! But your bonds lose 10 percent (Figure 24.2). Boo hiss.

Figure 24.2 $200 Investment, now $250. Up 25%.

You now have $160 in stocks and $90 in bonds. You made $50. That's 25 percent. Fantastic! This is great! Life is good!

But now you have a problem. Your portfolio morphed. It's not 50/50 anymore. It's now 64/36.

Your portfolio changed all by itself. You don't want that to happen. It's okay to be at 64/36 as long as it's your decision, but you don't want your portfolio deciding for you. Why not? Why not let the successes of your investments guide you? Because history shows that the investments that go up the fastest are the ones most likely to go down next. Think about technology stocks. Remember how fast they went up? Remember how fast they came down? Or how about real estate? I know it sounds counterintuitive, but the investments that are doing the best are the ones that carry the most risk.

Not only is your portfolio now unbalanced, but 64 percent of your portfolio is invested in the risky assets, the ones now most likely to go down. Not very smart. You need to manage your investments. Don't allow them to decide how you should be allocated. Do you really want the majority of your investments to be in the stocks that rose so quickly? Remember that a decision not to sell is the same as a decision to buy. You didn't originally decide to buy that percentage of those stocks. You decided that your portfolio should be split 50/50 between stocks and bonds. You need to rebalance it to reflect that decision. Take charge.

Reap the Rewards of a Rebalanced Portfolio

Rebalancing your portfolio gives you several benefits.

1. Step Number 1: Rebalancing forces you to buy low and sell high.

   You have to buy an asset from the slice of your portfolio pie that has gone down, and you have to sell an asset from the slice that went up (Figures 24.3 and 24.4). Mathematically, there is no escaping it.

Figure 24.3 Rebalance $250 Portfolio to 50/50

Figure 24.4 Rebalanced $250 Portfolio

Step Number 2: Rebalancing acts as both a buy and a sell strategy.

When rebalancing your portfolio, you sell investments. Rebalancing acts as a sell strategy by telling you what to sell and when. It also behaves like a buy strategy, letting you know when you needed more of certain assets.

Step Number 3: Rebalancing takes your emotions out of the equation.

Let's suppose I was your advisor. As in our example, we had decided on a 50/50 portfolio split. Then we had a gain on one side and a loss on the other. Your portfolio ended up at 64/36. Now we need to talk. I call you on the phone and say, “We need to rebalance your portfolio, so we're going to sell some of the assets that are making you 60 percent, and we're going to buy a bunch more of the investments that are losing you money.” How would you respond to this particular phone call? Let me guess: “What? Are you nuts, Ken? I don't want to do that. In fact, I want to sell all of that ‘minus-10 stuff’ and put all of my money into the investments that are making me 60 percent!!”

This, of course, is not a good idea. You'd be taking much too much risk. But it's what your emotions would tell you to do. Emotions are not your friend when it comes to investing. They will lead you astray. Rebalancing provides you with a disciplined selling strategy and allows you to make investment decisions without being misled by your emotions.

Step Number 4: Rebalancing helps to control your risk in the long run.

Numerous studies have supported the fact that rebalancing mitigates risk. Even better, studies indicate the potential for increased returns. Anyone out there want to make more money with less risk?

Getting Off the Titanic

Less risk is the name of the game now that you're retired or retiring soon. By rebalancing your portfolio you are keeping yourself within the risk profile that you decided was appropriate for you. But sometimes a balanced portfolio may not be enough to save you from a bear market. What do you do when the market is eating all the slices of your portfolio pie? If all your investments are going down at the same time, you can rebalance all you want, but all you're doing is moving the deck chairs around on the Titanic. It might be better for you to get off the ship and into the lifeboat. When it comes to your investments, that lifeboat is called “Cash!”

You are in charge of getting out of the game. Don't let your investments lead the way. It's your retirement we're talking about. Take charge. Be proactive. Be the boss.