We’ve got something that may sound like a riddle at first, but this situation captures an idea that we apply here in the shop.
Suppose you took some of your money and split it equally between two stocks, both trading at $20 per share.
Let’s say that after a year or two, one of the stocks rose to $30 while the other fell to $10.
Another year or two later, they leveled out again, and both stocks were back at $20. But your investment has not been a wash. How?
It might appear that your holdings are right back where you started. There is, however, a simple portfolio management strategy that can help us take advantage of back-and-forth movements.
Imagine if you had rebalanced your holdings in the two stocks when one went to $30 and the other went to $10. If you had sold off a third of your $30 stock and put the cash toward the $10 stock, you would wind up having twice as much of the cheap stock as you did of the expensive stock—and bringing both positions back to the dollar amount they were when you originally bought in.
But now when the high-flying stock gives up its gains, you already took some out, so now the price decrease affects a smaller portion of your portfolio than if you’d held onto all the shares. Similarly, when the depressed stock recovers, you get to enjoy the ride up with more shares than you took on the ride down.
Using rebalancing, this situation would leave you sitting on a net profit of one-third of your original investment—even though both stocks are back at the same price they were when you first bought them!
Rebalancing works because it applies the simplest investing axiom: “buy low, sell high.” When you rebalance your portfolio, you are selling a little bit of the higher-priced stuff in order to buy a bit more of the lower-priced stuff.
Trying to “time the market” is a fool’s errand; rebalancing takes the guesswork out and turns it into a matter of arithmetic.
As always, there are no guarantees: in the above scenario, if the cheap stock kept going down from $10 to $5 and the expensive stock went from $30 to $60, you would look awfully silly (… although not as silly if you had sold out of the one entirely!).
Stocks do not go up forever or down forever: We generally expect a lot of back and forth. By taking on the risk of missing out if there ever is an extended period without back and forth, we have a chance to use the back and forth to our advantage.
Clients, when you have any questions about what this means for you, please call or write.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
Investing includes risks, including fluctuating prices and loss of principal.
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