Market Bubbles Are Inevitable -- Portfolio Bubbles Are Not

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 2007. The good news is that your personal investment portfolio can easily be immunized against bubbles by implementing a rules-based 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 or misused.

The traditional approach to rebalancing is calendar-based. That means the portfolio is rebalanced back to the original allocation at predetermined times, usually annually. The problem with the calendar-year approach is that it doesn’t allow you to react to sudden changes -- and sudden opportunities -- in the market. Consider March 2009 as an example. The S&P 500 hit a low of 666 on March 9, having fallen over 25% from January 1. At that point in time, investors who held a traditional portfolio mix of 60% equity and 40% fixed income would have found themselves with a significant overweighting in fixed income. Using an annual calendar-year approach the investor would have simply left the portfolio as-is and waited for December 31 to make changes. As a result, their under-weighting in stocks would have lessened their portfolio’s gain from the subsequent S&P 500 increase from 666 in March to 1115 at year end.

“Rules-based” rebalancing offers a more effective approach to managing risk and boosting return. Here’s how it works. When the portfolio allocations are initially determined, a "rebalancing threshold" is also established and rebalancing occurs whenever that threshold is hit. You can make it as simple or complicated as you like. The simplest approach is to group similar asset classes together -- e.g., U.S. stocks, international stocks, U.S. bonds, international bonds, and specialty assets. In this example, you might have a 30% allocation to U.S. stocks and set your rebalancing thresholds at 27% and 33%. In other words, any time this asset class is over- or under-weighted by 10% or more, you’ll rebalance it back to the target. A narrower approach would identify targets for each specific asset class (e.g., large-cap U.S. growth stocks, emerging market bonds, real estate, and commodities).  Using this approach, an original portfolio allocation of 10% to large-cap U.S. growth stocks might have rebalancing thresholds of 8% and 12%.

The drawback of rules-based rebalancing, outside of a tax-deferred account, is the tax implications of the buy and sell transactions. However, while tax implications must be considered they should never drive your investment decisions. The major benefits of rules-based rebalancing are its systematic approach and its ability to compensate for investors’ emotional tendencies to chase performance and throw in the towel just when the market hits bottom and the rebound begins. Rules-based rebalancing is not a panacea, but it will prove an effective strategy for most portfolios.

For more detailed information about rules-based rebalancing, see my newest book, Your Nest Egg Game Plan.