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 a profit. This concept of buying discounted products/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 what we thought was cheap and see it as having actually been expensive relative to its new price.
How then, does one consistently succeed at buying low and selling high? We think one of the simplest approaches is to periodically 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 markets 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 by 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 we don’t know the future, we have no idea when that run up will end or when the decline may turn. What we 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 to the mean by declining. This makes sense when you consider the fact 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 we're 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 as investors, we want to be aware of that by staying up to date on various aspects of the economic environment. If you’d like to learn more about the concept of mean reversion and how we at Cedarstone invest for value, I invite you to poke around the rest of our articles, particularly those under the “Investing” category or give us a call!