If you own mutual funds it means you are going to have to decide what to buy, when to buy and when to sell at some point. This is known as rebalancing. But how do you know when to rebalance your mutual funds? The question comes up often and it’s crucial to address before you even start investing. When and how you rebalance has a direct and significant impact on your results.
The best way to approach this topic is to first consider what your overall goals are. For most of us, the goal is to have more retirement income later on. So regardless of which investment strategy you use, it makes sense to have a well-articulated and fully understood criteria to use when you rebalance your funds. Let’s look at 3 different ways people make this decision and determine which model you might want to use.
OPTION 1 Rebalance when you feel like it.
On the face of it, this may seem like a ridiculous way to manage money. But the reality is, many people use this exact strategy and they don’t even know it. For example, have you ever said any of the following?
- “I just know that (gold/China/real estate/Harry Potter paraphernalia) is going to do well. Everyone is buying it. I’m going to get in while I still can.”
- “The election is coming up. Mr. Squarepants is going to win this year. I know the market is going to tank. Get me out now.”
- “Interest rates have just got to skyrocket. Let’s buy silver.”
- “I have a really good feeling right now. Let’s……..”
If you have ever made investment decisions based on statements like these, you are investing based on your feelings. Don’t get me wrong. Your intuition might be right once in a while. But at the end of the day you are investing based solely on your gut. And it’s dangerous to rely on feelings when it comes to the financial future of yourself and your family.
I’ll even go one further. Some of the statements above may even seem logical at a given time. But if you notice, every single one is based on one person’s sense of what things mean rather than data and how that data relates to an investment model. Predictions based on observations and feelings are not reliable investment tools. You may get it right once in a while but over the long run, you’ll come out on the short end of the stick.
Do you know anyone who “got it right” and sold everything before the crash of 2008? I know plenty of people like that. They were extremely fortunate and/or smart that time. But the problem with most of these people is that they continued to refrain from investing ever since 2008. As a result they missed out on some banner returns ever since. The reason? They invested based on their feelings rather than relying on an investment strategy.
OPTION 2 Never Rebalance
Some people never rebalance their investments. This is known as a “buy and hold” strategy. The only reason these people buy or sell a fund is if:
- They need money from the account.
- They have more money to invest.
- Their situation changes dramatically. For example, if you are investing long-term but decide to go buy a home, your long-term investment becomes a short-term investment because you’re going to spend that money. As a result, it would probably make sense to rebalance into a much more conservative portfolio.
Buy and hold investors have a system. It’s pretty straight forward but it is a system. To be frank, I’m no fan of buy and hold but I do respect people who use this approach because it is methodical. It has benefits and drawbacks.
The benefit is that it is very simple. The chief drawback is that it can subject you to horrendous investment losses. The S&P dropped 38% in 2008. Over the last 100 years, we can observe that there has been a bear market approximately every 3 to 5 years. That’s a spicy tamale and one that not many people have the stomach for. That’s why many investors abandon the buy and hold strategy at the worst time and they become emotional investors from that time on.
Look at the first graph below. Can you imagine how difficult it is to hold on?
Now, if you look at the graph which shows what happened to the S&P in the months and years after 2008, it seems a bit easier to take.
But the issue is, when you are an investor, the only picture you have is the first one. You don’t know what the future holds. Investors don’t have perspective real-time so their fear often takes over. This is my chief complaint with buy and hold investing.
But at the end of the day, if you can handle this kind of gut-wrenching investment experience, buy and hold might be a good way to invest. As a result, you may rarely need to rebalance your account.
Option 3 Rebalance when the market shifts.
This is called “market timing” but not all market timing strategies are alike. Some people “time” their investments based on monthly or quarterly data. Other people use market timing to rebalance every day. Since market timing is such a broad term, it’s impossible to say that it is a good or bad approach.
My suggestion is that if you do employ a market timing (or market sensitive) approach you do so in a way that is consistent with your temperament. Also, if you decide to use a certain approach, make sure that method has a good track record. Finally, I always apply the “sleep at night” test to my investing. If I can’t take the worst case scenario and still sleep at night, I know the approach isn’t for me.
Ultimately, you should rebalance your portfolio in a way that is consistent with your long-term investment goals and risk profile. In other words, first be clear on your goals then decide on which investment strategy is the best way to accomplish those goals. Once you are clear on these two points, it will be easy to know when to rebalance.
How do you rebalance your accounts? Why? What has been the result (good and bad)?