Rebalancing as a Part of an Investment Plan

In order to be a successful investor, one needs to have a plan which specifies when investments should be purchased and in what quantity, and equally as important, when an investment should be sold. This plan should be in writing, especially so it can be referred to and adhered to in times of stress and emotional upheaval. Otherwise, the investor will be subject to whims and possibly, prone to make decisions based on emotions and or current events, both of which often result in poor results. The plan that is typically used for this purpose is called The Investment Policy Statement, or IPS for short. It is very important that the IPS be written down and referenced periodically, especially in times of stress.

Let's examine one component included in all Investment Policy Statements that I prepare. This is a concept called re-balancing, and when viewed in the context of the stock market in the last few years, I believe it provides a wonderful example of the importance of the written IPS. We will consider the five years that ended on December 31, 2010 and use a very simplified example; this example should demonstrate just how different the results may have been if we followed "our gut" rather than sticking to a "plan". Please remember that this is a very simplified example that simply uses index returns and does not account for trading costs or taxes.

For purposes of our example, let's suppose that we start with a portfolio of $100,000 on January 1, 2006, and that 60% of the assets were placed in the US Stock Market, as represented by the S & P 500 index. I will further assume for this example that 40% of the assets were placed in the US Bond Market, as represented by the Barclays Capital Aggregate Bond Index. As of December 31st of each year we will sell whichever asset is higher than its original allocation percentage and purchase whichever asset is less than its original allocation percentage. Stated differently, we are selling what has just performed best and purchasing what has just performed worst; this is a difficult concept to grasp and goes against what most of us would (emotionally) be inclined to do, since the natural tendency is to stay with the winners and dump the losers.

Now try to think back to December 31, 2008, when the stock market was in the midst of the worst market decline that most people alive had ever experienced. At the beginning of the year, the equity portion of the portfolio was 60%; as of December 31st, it had been reduced to well less than 50% of the portfolio. The feeling at the time was that the decline was going to continue, but if one had the fortitude to continue with the plan, they would have been well rewarded since the stock market went up by approximately 26% in 2009.

As a matter of fact, during these five years, if an investor had followed the plan discussed above, the $100,000 that they started with at the beginning of 2006, would have been worth approximately $4,200 more than if he or she had simply bought and held. This represents a gain of over 4% of the original amount over the 5 years. Keep in mind that while I believe that in the long run, that re-balancing works; there are period of time when it does not – so educate yourself before implementing this or any other investment plan.