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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?
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.
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.
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?
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.
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?
And we can.
Photo credit: Jiposhy .com @Flickr