One of the often-quoted tenets of good investing is to buy low and sell high. Similar to commercial spending – you want to purchase things that are cheap or on sale and when you sell something you want to sell it for the greatest profit possible. This concept of buying discounted products or investments and selling them at a premium is a relative one and, as we’ve written before, is harder to do when you don’t know that future. Something may seem cheap now but may become significantly cheaper in the future to the point where we may look back on something we thought was cheap and see it as having been expensive, relatively speaking.
How then, does one consistently succeed at buying low and selling high? We think one of the simplest approaches is to rebalance your portfolio. Let’s say that at the beginning of your portfolio’s life you decide that, given your beliefs about the markets and investing, your portfolio should be 20% international stocks, 10% emerging market stocks, 30 % U.S. stocks, and 40% bonds. A year later you check on your portfolio and notice that because international and U.S. stocks have done well, and emerging market and bonds have underperformed your portfolio is now 22% international stocks 8% emerging market stocks 35% U.S. stocks and 35% bonds. You rebalance your portfolio by selling 2% of your international stocks and 5% of your U.S. stocks and buying 2% of emerging market stocks and 5% of bonds.
“But didn’t you just say we don’t know the future!” I sure did! It feels uncomfortable because we’re selling winners and buying losers. The U.S. stock market may still have room to run, or the emerging market stocks might have further to fall. The problem is, because I don’t know the future I have no idea when that run up will end or when the decline may turn. What I do know is that over the long run, investments are known to mean revert. Mean reversion is the idea that there is an average upward trend that the markets follow but that in the short run, investments rise above and fall below that average. When they rise too far above the average they revert by declining. This is the idea that when something gets too expensive, individuals cease to be willing to pay the current price and the price falls. Conversely, when something declines too far in price it starts to look like an attractive opportunity because it is “cheap” and as other individuals start buying it, the price rises in a mean reverting fashion. So really, rather than selling the winners and buying the losers, what I’m trying to do overtime is sell the expensive investments and buy the cheap investments.
There are instances where rebalancing doesn’t work. When there is a permanent economic change, it may be wise to reduce the portion of our portfolio allocated to a certain investment. Something that may initially seem cheap may actually be adjusting to a new normal average and we want to be aware of that as investors by staying up to date on various aspects of the economic environment. However, having the discipline to rebalance can often help achieve that elusive goal of buying low and selling high.