Market down? It’s time to rebalance your portfolio!

Looking at the market when it seems to be relentlessly going down is a gut wrenching experience. Especially if you aren’t used to bear markets. Those of us who have experienced longer periods of investment know that there inevitably are recessions/bear markets every few years. But after a period of time, the economy improves again, company profits go up and hence their stock prices. The worst thing you could do in such a time period is panic and sell your shares to move into cash. There is however one trick you can use to turn a downmarket to your advantage,

A typical retirement portfolio consists of Stocks and Bonds according to your asset allocation. Eg: 80% stocks and 20% bonds. Sometimes after a while the allocations drift from your target. Rebalancing brings your portfolio back into alignment and at the same time allows you to “buy low” the assets that have declined and “sell high” the assets that have relatively gone up.

For example when there is a short term decline in the stock market, your portfolio might now be 75% stocks and 25% bonds instead of 80/20. Now you sell 5% worth of bonds and buy 5% worth of stocks. This has the effect of selling the asset which is high (bonds) and buying the asset which is cheap (stocks). You can do the same in the other direction: if stocks have had a big run up, you can sell some stocks and buy some bonds.

 

In the example above, the market (eg: S&P 500 index) has fallen by 25% and then recovers back to original level. The effect of rebalancing is that you are up 1.33% above the original point even though the market itself seems to have gained 0%!

You shouldn’t need to do rebalancing more than once a year. Keep an eye out on tax implications! Rebalancing is best done in your tax deferred accounts (IRA, 401K etc) to avoid capital gains taxes.

Follow this method and you can see the silver lining in the dark clouds of a down market!