Market Bubbles Are Inevitable; Portfolio Bubbles Are Not

by Dave Clayman, CMT®, C(k)P®, AIF®, CPWA® Co-Founder and Principal

Individual investors can find many ways to lose money in the stock market, but the most frequent is their tendency to buy-high and sell-low. It’s human nature. We get more confident when things are going well, and we become cautious and fearful when they’re not. So we load up on stocks when the CNBC talking heads are cheerleading the latest highs in the market, and we sell when their tone leaves little doubt that Armageddon is just moments away. Sadly, this natural tendency is exacerbated by the stock market’s unfailing ability to rocket too high and plummet too low.

So the bad news is that there will always be market bubbles like we had in 2000 and 2008.

The good news is that your personal investment portfolio can easily be immunized against bubbles by implementing a rebalancing program. It’s simple; it removes emotion from the decision to buy or sell; and it can permanently remove “bubble” from your investing vocabulary.

The basic concept of rebalancing is familiar to anyone who has sat through a 401(k) enrollment meeting or browsed an issue or two of any personal finance magazine. It’s a basic principle of investing, but it’s a principle that is usually ignored. The traditional approach to rebalancing is calendar-based. That means the portfolio is rebalanced back to the original allocation at predetermined times, usually annually or semi-annually.

Here’s a simple example of how rebalancing works. Let’s say you originally had a 30% allocation to U.S. stocks, 20% to foreign stocks, and 50% to fixed income. Over time the actual percentage of money allocated to those three asset classes will fluctuate with the market. In recent years, the U.S. stock market has done very well, foreign markets have struggled, and the bond market has been relatively flat. That means your allocation today might be 40% to U.S. stocks and 10% to foreign, with fixed income remaining at 50%. In the process of rebalancing, you would sell some U.S. stock positions and buy foreign stock in order to get back to your intended allocation of 30%/20%/50%.

We realize this is counterintuitive for most investors who often invest in the asset class that has performed best in the near-term. The markets, however, have a tendency to even out over time – so you’ll do better by selling the top performers and buying the laggards. An automatic rebalancing program will make the decision to buy or sell for you – and will help reduce risk and improve performance over time.

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