Rebalancing: How to Buy Low and Sell High

Wanderer
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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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This is part of our ongoing series on investing. Part 1: Index Investing, Part 2: How To Build a Portfolio, Part 3: Asset Allocation: Slicing the Pie

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Buy Low, Sell High.

It’s the entire point of stock investing, and on the surface it seems pretty self-explanatory. Find a stock you think that’s going to do well (using whatever magical method you see fit), buy it at a low price, then sell if when it shoots up and make a killing. It may not be easy, but it’s at least simple, right?

Is it simple?

For a moment, let’s pretend you’re in this scenario. You are having a drink after work and you overhear these two guys in thousand-dollar business suits talking in the booth next to you.

“Yo Brah! I just got this inside scoop from my source at Bloomberg! This company Acme’s stock is about to shoot through the roof! They make, like rocket powered roller skates and fake tunnels and signs that say “Free Bird Seed” or some shit, and the Wile E. Coyote people are about to sign a huge contract with them! It’s gonna be off the hook!”

I don’t know why these fictional stockbrokers sound like douchey frat guys, but in my head they just do for some reason.

“You picking any up?”

“Hells, yeah, Brah! I have an order for 100G’s going up first thing tomorrow morning! You gotta have balls to make easy money, amirite?”

So you rush back to your computer at work and look up the company. Yup, it exists, and yup, it makes all those things those suits were talking about. So you take a deep breath, convince yourself that you too have the balls to make easy money, and you hit buy.

Now, this is the part where I’m supposed to say the stock tanks and we all laugh at the stupid fictional character that took stock tips from people who say “Brah,” but let’s consider the scenario where they were right.

The contract does in fact come through and the stock quadruples in price, and your ballsy $50,000 investment is now worth $200,000. Woo hoo, right? Break out the champagne! You took a big bet and it paid off!

But now what do you do?

It’s not actually clear what you should do at this point. If you sell, you realize your gains, but the stock could rampage higher and higher and you would have missed out on even more free money. But if you hold on to it, that customer could actually catch that damned road runner and then wouldn’t need to buy any more Acme products, causing the stock to crash. If that happens, then your gains vanish.

So what do you do? Hold or Sell? Hold or Sell?

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And right there is the biggest problem with nearly all stock-picking strategies available to the general public. They tell you what to buy (often incorrectly) but they don’t say anything about when to sell.

Which brings us to the final pillar of the investing strategy that made us millionaires, the other two being Index Investing and Modern Portfolio Theory.

And that pillar is: Rebalancing.

What does that mean? Simply put, once you’ve created a portfolio of Index Funds carefully selected to your personal risk tolerance (eg. ours is 60/40), you monitor your asset allocation. If it ever falls out of line with your target, you rebalance it, meaning you sell assets that have grown too big, and buy assets that have withered.

So if your target portfolio is 60% equities, and 40% bonds, and equities have had a good year, at the end of the year you may be 65% equities and 35% bonds. So, to restore your original asset allocation, you sell 5% of your equities and buy bonds.

Why is this a good idea? Because it forces you to sell stuff that’s done well (Sell High) and buy stuff that’s done poorly (Buy Low). And the best part is that this rule removes all emotion from the decision. Is it above target? Sell. Is it below target? Buy.

Rebalancing tells you what to do as the market gyrates, and it always tells you to do the thing that makes you money in the stock market: Buy Low, Sell High.

Now here’s the part where I tell you the big caveat. There’s always a big caveat, isn’t there?

Rebalancing only makes sense combined with Modern Portfolio Theory and Index Investing

What? Why? Rebalancing as an idea seems pretty solid on its own, doesn’t it? Shouldn’t it apply to stock pickers?

Short Answer: No. Long Answer: HELL NO.

Pretend you’re a stock-picking genius. You’re sitting in your red velvet Lazy-Boy watching the New Year’s Eve countdown in 1991. Shoulder pads are a thing, Full House is still on air, and Justin Bieber is still 3 years away from being born and destroying the stereotype of Canadian politeness.

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But you JUST said “never”. *eye roll*

But you aren’t just like everyone else. You are a visionary. Nay, a genius. And with balls of steel, to boot. And you foresee the potential of this tiny little thing called the Internet. So you choose two companies, one that builds the wires the Internet goes through, and the other a company that makes computers that connect to said Internet. Two companies, named Nortel and Apple.

Rebalancing works with indexes, but it absolutely does not work with individual stocks. Why? Well, strap in and find out.

Let’s say you evenly bet on these two companies. You split your $1 Million (you’re surprisingly rich for some reason in this fantasy) between these two companies. $500K Nortel, $500K Apple. And every year, you review your 2-asset portfolio. What do you find? Over time, Apple goes higher, and Nortel goes lower. So what does rebalancing tell you to do? Sell Apple, Buy Nortel.

Starting to see the problem?

1059px-Operation_Upshot-Knothole_-_Badger_001
Oopsies.

Rebalancing, as a strategy, completely falls apart with individual equities. Because it’s absolutely possible for individual equities to go to zero. But not for an Index.

Rebalancing would tell you to sell off your successful Apple stocks to buy Nortel stocks, which as we know would eventually turn out to be worthless.

But rebalancing combined with Index Investing is a very powerful combination.

As we’ve written before, Indexes can never go to zero. So rebalancing causes you to buy low, and sell high into assets that have historically gone up, and will continue to go up.

And while there’s plenty of evidence that rebalancing adds return to your portfolio over time, rebalancing’s real value comes when the world’s on fire.

Because when the world’s on fire, stock markets crash like crazy. Our most recent stock market crash in 2008 saw the S&P500 drop by 50%! What do you do when that happens?

Well, turns our rebalancing tells us what to do. As your allocation goes out of whack, you sell the thing going up (bonds) and buy the thing going down (stocks). In fact, stocks were dropping so fast, we had to not only sell bonds, we had to take their interest plus money earned from our jobs and throw it into stocks, an asset class that was basically on fire. It was not fun, but we did it anyway.

And as a result, we pulled off something most Wall Street traders couldn’t: We didn’t lose money in the Great Financial Crisis of 2008.

And that’s why I wrote this Investment Series. To tell you that these 4 concepts: Part 1: Index Investing, Part 2: Modern Portfolio Theory and Part 3: Asset Allocation: Slicing the Pie, and Part 4: Rebalancing, are what we used to succeed in the stock market.

Read it, study it, argue about it. Whatever. But this is what we did, and it worked out spectacularly for us. But we aren’t special. Any of these strategies we implemented can be done by anyone.

Including you.

And you know what? Ever since we learned, grasped, and embraced these relatively simple strategies about personal finance, investing has become easy. Whenever the market drops, we just sell stuff that went up and buy stuff that went down. And vice versa.

The biggest success of Wall Street was to convince the masses (us) that investing is hard, and that we can’t pull it off ourselves.

And you know what?

It’s not.

And we can.

photo credit: Jimee, Jackie, Tom & Asha @Wikipedia
Photo Credit: Jimee, Jackie, Tom & Asha @Wikipdea, CC BY-SA 2.0 license

References:

Photo credit: Jiposhy .com @Flickr

 

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49 thoughts on “Rebalancing: How to Buy Low and Sell High”

  1. Hi, big fan of both of you, the blog, FI, everything.

    Can you elaborate on this piece?

    “And as a result, we pulled off something most Wall Street traders couldn’t: We didn’t lose money in the Great Financial Crisis of 2008.”

    Yet as per that 2008 post here is your entry:

    “Investment Gains/Loss: -$58,000
    FUUUUUUUUUUUUUUUCCCCCKKKKK”

    Cheers,
    David

    1. The Great Financial Crisis started in 2008 but it didn’t end until 2013. What we were trying to say there is that at the end of 2008, we did have loses, but because we bought into the storm (rebalancing) instead of selling, we recovered the losses the following year and were back to even by 2009.

    1. Good question. Generally once a year if nothing interesting is happening. When a large move is happening, we rebalanced more frequently, like once every 6 months. Back in 2008, we were rebalancing every 2 weeks, essentially getting any money we could find and throwing it into the fire.

  2. Love your articles. Also love the frequency of your posts. But please pace yourself so you don’t get burned out. You’re retired after all!

    1. Great question! We keep 5% of the portfolio in cash. So when we decide to rebalance, we look at the winners AND cash and rebalance with both to get them back to the desired ratios. Basically cash is just another asset.

      1. How many percentage points (up or down) do you allow a particular holding to move before it’s re-balanced? i.e. +/- 3%, 5%, 7%?

        Thanks,
        Matt

        1. I’d say +/-5% off target is where I’d consider it. So for example, if something is 20% allocated, and goes to 21%, I’d start looking at it, because 1% is 5% of 20.

          1. Hi Wanderer,

            I am bit confused by this statement. If its +/- 5% off target, then you would re-balance like every few weeks, no? Earlier, Firecracker mentioned re-balancing every year if nothing big is happening in the market or every 6 months otherwise.

            Would it make sense to re-balance +/- 5% on the 20% as a whole? For example, if equity goes below 15% or above 25%?

            Thoughts?

  3. How do you re-balance your equity portion if it’s less than your fixed income? Assuming your equity investments are in the TFSA, and your bonds and REITs are in the RRSP, wouldn’t transferring your gains from RRSP to TFSA result in withdrawal taxes which could possibly negate your gains? Or do you re-balance by buying more equity?

    Thanks and loving your blog!

    1. Correct, never incur an RRSP withdrawal just to rebalance. In this case, you would sell bonds held in your RRSP, then buy equities still in your RRSP. We’ll talk more about tax strategies in the next investment article.

      And to answer your questions about buying more equity, the answer is yes. When we worked, we would use any cash that we earned to help rebalance, essentially buying more index funds with each paycheck. Now that we’re retired, we would have to raise that cash by selling the stuff that went up. But both approaches are fine and work just as well.

      1. Thanks for your response. Yeah, I never thought of putting equity investments in the RRSP. I always thought putting them in the TFSA to maximize the gains but in this case, I guess it makes sense to hold some in the RRSP.

      2. Loved this post Fire. You mentioned talking more about tax strategies later on … is there somewhere we can read about that? Learning a lot from you guys. Thanks!

  4. “And while there’s plenty of evidence that rebalancing adds return to your portfolio over time, rebalancing’s real value comes when the world’s on fire.

    Because when the world’s on fire, stock markets crash like crazy. Our most recent stock market crash in 2008 saw the S&P500 drop by 50%! What do you do when that happens?

    Well, turns our rebalancing tells us what to do. As your allocation goes out of whack, you sell the thing going up (bonds) and buy the thing going down (stocks). In fact, stocks were dropping so fast, we had to not only sell bonds, we had to take their interest plus money earned from our jobs and throw it into stocks, an asset class that was basically on fire. It was not fun, but we did it anyway.

    And as a result, we pulled off something most Wall Street traders couldn’t: We didn’t lose money in the Great Financial Crisis of 2008.”

    Ok, so in fact, you did lose money in the downturn, but unlike many, did not panic and it all came back. Your close but not quite there yet. Rebalancing every 2 weeks or every month, pulls money out of the Equities which is the only way to generate income today. Not a good strategy. Markets as of the last 20 or so years, have been moving in about 6-10 year cycles give or take, so why rebalance at the beginning of the cycle? there is no need.

    At the top of 2008, I had rebalanced to about 60/40, then at the bottom sitting at 40/60, started to move back into a mixed bag of equities, index funds, and Canadian Dividend. I have let it ride until 2 years ago, where I started to rebalance over the last 2 years. Now at 50/50. (I have short term needs this year, else it would be 60/40)

    My point… I have left most of my capital in during the full market cycle, not rebalanced at the beginning and have achieved a much higher capital appreciation, without any added risk. Now when a down turn comes (and it will, this is one thing you can be sure of ) I have cash to put back in (Rebalance)

    Long term, the markets average is about 7%, with dividends you can up that to about 8%, Housing is about the same on average. So pulling your money out early, is not going to do you any good. Neither is buying down, which is why I suggest watching the 3 and 6 month price curve. If eather is in negative, hold off. Start a repurchase of Equities when a bottom has been reached, I lost 3000.00 buying down during the 2000 crash, big mistake, still has not come back 16 years later.

    love the blog… good work… enjoy life…. and hey…. have a couple of kids…

    cheers
    D.

    1. 1) “Start a repurchase of Equities when a bottom has been reached..”

      Interesting points, but no one has a crystal ball to predict when the bottom has been reached. That’s market timing.

      2) “Long term, the markets average is about 7%, with dividends you can up that to about 8%, Housing is about the same on average.”

      Historically, housing has not be increasing at the same rate as the markets. In fact, it’s only been increasing at the rate of inflation. It’s only been performing well due to abnormally low interest rates. That won’t last forever.

      And thanks! Appreciate your thorough analysis.

      We would love to have kids…the trick is to get over the mental block of all the work required to take care of them. Any advice?

      1. In our case the trick was to become accidentally pregnant, at about your age. Best thing that ever happened to us. Tomorrow that baby boy turns 13, and we still can’t believe how lucky we were/are to have him. The rewards outweigh the work. He is worth more than your million dollars, and makes our lives rich! But I do think it’s a good idea to have a couple of full years beaching it first, so enjoy it. Thanks for your fantastic blog.

  5. Great series.
    I want to ask if you have considered leverage in investing and covered it somewhere? Does it make sense with rebalancing, asset allocation, MPT, and index investing ?

    1. No, leverage doesn’t work with indexing and rebalancing. It comes with call risk. So when the markets plummet your loan gets called and you’re forced to sell at the bottom. Margin is how the 1929 stock market crash turned from a crash into a catastrophe.

    1. Hopefully, your 401k provider has a suitable index fund you can use. If not, you’ll have endure a less than optimal fund (to take advantage of employer matching), and once you retire, you can get the money out using a “Roth IRA conversion” ladder (which we will be writing about next Wednesday).

      1. Hey FIRECracker. Thank you. Yeah, after reading the article you guys put up on “index investing”, I checked and my company had several index funds (S&P 500 Index, a few Large Value & Growth Index funds based on Russell 1000, some mid & small index fund, and international index funds) as part of its 401k package, so I just moved most of the assets to a few of the index funds and a high yield bond (90/10 asset allocation)

        Looking forward to the ROTH IRA Conversion article. Keep up the good work.

  6. Recently found your blog, and I am chomping at the bit to start investing. I have some money saved & was literally considering real estate & index funds. I’m in the gathering as much information as humanly possible phase, before deciding what I feel comfortable doing going forward. I wanted to know what your opinion was on those internet companies Betterment & Wealthfront, which promote exactly what your talking about??? Are their fees acceptable, is it a viable option, or is it better to DIY?

    1. Don’t have any experience with Betterment & Wealthfront. We’ll do some investigating and write up a post about it in the future.

  7. Hi, thanks for doing this! I have a few questions. My wife and I have many investment vehicles: personal rrsps, work grsps with 4% matching, tfsas, etc. What investment accounts did you guys use to get where you are? Do you suggest keeping work grsps for the matching? Did you guys combine your money together into one investment account so you had more money working for you guys? Did you guys each keep a separate registered and non registered investment account? Thanks for your time!

    1. Yup, definitely keep the work grsps for the matching. We kept ours separate for employer matching. We combined them when we left.

  8. I love your blog. Very informative! My husband and I are in a similar position, we are both 30 and have high paying jobs. We save a lot of what we make. We have a baby though! Question: do you think it is acceptable to buy only S&P 500 Index as your whole portfolio if you have 10-15 years before retiring? Also if we were to do asset allocation would only buying Vanguard S&P 500 Index (VOO) and Total Bond Market (VBMFX) funds be sufficient at 60/40 or are there other financial vehicles you would recommend? Thank you so much! Also do you prefer Roth or regular 401k? We are American and it’s really anyones guess as to whether capital gains tax will go up or down over the next 50 years. Do you sell your stocks and bonds funds at 4% each year to cover your cost of living or do you have special dividend paying funds? I’m very uneasy about going to a financial advisor and I like investing with Vanguard because of the low fees. Any advice would he great!

    1. Thanks, Lauren!

      Okay to answer your questions:
      “do you think it is acceptable to buy only S&P 500 Index as your whole portfolio if you have 10-15 years before retiring?”
      – If your investment horizon is long, it makes sense to go aggressive, but I wouldn’t go above 75/25. The key is to make sure you don’t panic in down markets and sell. If you have some bonds, it gives you the ability to rebalance during a crash.

      ” Vanguard S&P 500 Index (VOO) and Total Bond Market (VBMFX) funds be sufficient at 60/40 or are there other financial vehicles you would recommend?”
      – I’d split up the equity portion to include some international exposure (I use the MSCI EAFE Index, so whatever Vanguard has that tracks this will work).

      Also do you prefer Roth or regular 401k?
      – We did a write up on this here: http://www.millennial-revolution.com/invest/let-government-fund-retirement/. Short answer: 401k which you later convert into a Roth in retirement.

      Do you sell your stocks and bonds funds at 4% each year to cover your cost of living or do you have special dividend paying funds?
      – We pivoted our portfolio towards higher-yielding investments such as REITs, Preferred Shares, and Corporate Bonds. Our portfolio yields around 3.5%, so we have to sell a tiny bit to cover our costs but not much. In the accumulation phase like the one you’re in, stick with Indexing since you don’t need the yield yet.

  9. Hi!

    What do you think is better:

    1) Invest in ETFs that cumulate their dividends and rebalance

    2) Invest in ETFs that distribute those dividends and live with that because even in crisis they distribute

    The catch: where I live (Luxembourg) dividends are taxed as job income, but gains on a sell are NOT taxed if you hold the investment for more than 6 months. So, theoretically, rebalancing could be a 0% tax life.

    Thanks (again) for your eye-opening blog!!

  10. Hi! I am really interested and thanks for doing this. I read so many articles about investment strategy and index is the best option but my question is how can find out the good companies for creating portfolio.

    Thanks

    1. This is a timely question. We’re actually reviewing low cost brokerages and robo-advisors right now. Will post a review soon and step-by-step guide soon.

      1. Looking forward to a series like this. I started a betterment account as an experiment a few years ago after MMM wrote an article on them. I have been pleasantly surprised by the ease of startup, user interface, investing tools/visualizations, and preliminary returns. I have about an 80/20 allocation and the auto rebalancing tool has been pretty effective so far. Definitely my easiest, most hands off investment with similar returns.

  11. Hey guys just discovered your website and FI method from your recent interview with the mad fientist. I’ve been binging on your articles, but particularly enjoyed this investment series. It is easier to digest than JL Collins or bogleheads while presenting similar methods. Really good stuff! I’ll be referring my friends and family to these articles when they ask why we work so hard towards FIRE and why we use the stock market/index funds as our primary investment vehicle. Cheers!

  12. Hello! awesome, just wanna check how often do you guys rebalance?
    and also, do you all put a monthly set amount into your portfolio or wait until you gather a certain amount?

  13. I have spent much a fair amount of time with investing over the years.
    Reading,buying stocks bonds mutual funds, using advisors, and buying without advisors, and using newsletters and television and Internet.
    Your investing series info is correct based on my experience. Your advice is shared by many, but outmarketed by many many more!
    Many individual investors including myself believe we lack enough knowledge to invest our own money wisely, particularly if it may contain any significant amount earmarked for retirement. Your information is based on facts! You make it very clear that most people are quite capable to invest properly on their own without a great amount of time and effort. My portfolio with a bank advisor has so many products and fees that I am having difficulty getting my total yearly costs for all of my investments.
    Your articles have given me the motivation to make a change! I find two Canadian publications that have suggested your strategy, one of which calls it The Couch Potato Portfolio ! Thank you very much!

  14. Saw an article on FB about you both and have started reading all your articles. What an inspiration! I am now crafting my early retirement plan. My two questions are 1) was your allocation during the years leading up to retirement a 60/40 split or more aggressive/ did it change over time? And 2) between vanguard total market and S&P 500 index which makes more sense? Right now I have my money in the total market and when I look at historical data seems to have performed better than S&P. Ok one more question any thoughts on including international equities/ gold/ commodities as part of balanced portfolio? Thank you!

    1. Welcome aboard!

      During our accumulation run up we mostly stuck to a 60/40 split because our time-to-retirement was relatively short. When we started investing seriously towards retirement, we were only about 5 years off, so we never went super aggressive since our investment horizon was never very long.

      We’re using the Vanguard Total Market in both Workshop portfolios. I think that one’s more diversified than the S&P500 since it includes midcap and smallcap stocks as well, but between the two they’re not THAT far off from each other.

      We do use international equities as part of our workshop portfolio and in my own personal portfolio, but no gold or commodities. Long-term, equities always go up over time because humans are toiling away creating value. Gold/commodities don’t, so I see investing in gold or commodities a form of market timing.

  15. Hi there,
    Just like the previous poster, I came across your blog and started reading… I must say, it’s just good old logical thinking.
    Now I’m not the big financial wiz but I am seriously considering to take your tips and hints to heart and start up my portfolio.
    I have a job that I love, we just moved from belgium to the south of france… because too many people are afraid to follow there dreams/heart. So therefore I am not interested in the short term. 15/20 years sounds perfect to me ;).
    Can I just ask with what amount you guys started out ? Could be that this info is all in your blog, but haven’t got the chance to read it all. (wich I will in the coming periode…
    Anyway thanks for the tips, your blog and your insights !!

  16. Hi – Congrats on all your publishing success and untold thanks for the though-provoking and CLEAR info…I have muddled through self-taught over 2 decades and have learned from a few gentle mistakes. I am just now building the significant returns from my lessons. My rrsp investment contributions over the years seemed so minimal, raising two kids, owning a rural home, and renovating… as a single mom. (Could write my own blog on the earlier emotional/financial decisions thru trial and error, lol!) Start with a little, beat the interest rates on your returns each year and WOW! I am now in a position where rrsp is no longer a primary option for investing and I am building within a TSFA portfolio.
    I wish to avoid the majority of learning/growing pains in that journey through tips and insights from others on the journey.
    Your info is so helpful with the work/and fun to get into the next stage, planning for retirement. ..and travel! So again, THANKS! MERCI! GRACIAS! DANKE!

    Awaiting with baited breath for the next installment in your Investment Workshop!

    In the meantime, I have a couple of requests/questions:
    1) Could you take some more time exploring the whole when/how/how much scenarios with Rebalancing a Portfolio?
    2) If you hold several equity funds (and several bond funds) and over time amongst the equity funds, some do consistently well and some have very conservative returns long-term, would you”rebalance” amongst those equity funds? (Sell portions of the moderate performers and reinvest early into the ones that continually climb?) Or is “rebalancing” only have to do with the bull/bear market positions and personal adjustments?

    3) Would it be possible to increase the focus on Canadian investing – TSX? I am having difficulty finding/choosing Index ETF’s with clear performance info…my favorites are iShares…but their performance is under 4% ….is that timing reading stats in the last two quarters?
    and I haven’t made much progress in finding International/Global ETF’s offered here.

  17. Hi,
    It seems as though re-balancing works because bonds and stocks rise and fall inversely.
    What if bonds and stocks fall at the same time?
    Is that even possible? I’ve stumbled across a few articles recently about bond bubbles in government debt.
    Any thoughts?

    1. It is possible but very rare. And when it does happen (example: people fleeing into gold and cash in times of fear), it doesn’t last long. So in the context of long term investing, it’s not relevant. In terms of long term investing, bonds and equities are anti-correlated.

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