Market Bubbles Are Inevitable; Portfolio Bubbles Are Not
Individual investors can find many ways to lose money in the stock market, but the most frequent is their tendency to buy high and sell low. It’s human nature. We get more confident when things are going well, and we become cautious and fearful when they’re not. So we load up on stocks when the CNBC talking heads are cheerleading the latest highs in the market, and we sell when their tone leaves little doubt that Armageddon is moments away.
Sadly, this natural tendency is exacerbated by the stock market’s unfailing ability to rocket too high and plummet too low.
So the bad news is that there will always be market bubbles like we had in 2000 and 2007. The good news is that your personal investment portfolio can easily be immunized against bubbles by implementing a rules-based rebalancing program. It’s simple; it removes emotion from the decision to buy or sell; and it can permanently remove “bubble” from your investing vocabulary.
The basic concept of rebalancing is familiar to anyone who has sat through a 401(k) enrollment meeting or browsed an issue or two of any personal finance magazine. It’s a basic principle of investing, but it’s a principle that is usually ignored or misused.
The traditional approach to rebalancing is calendar-based. That means the portfolio is rebalanced back to the original allocation at predetermined times, usually annually. The problem with the calendar-year approach is that it doesn’t allow you to react to sudden changes — and sudden opportunities — in the market.
Consider March 2009 as an example. The S&P 500 hit a low of 666 on March 9, having fallen over 25% from January 1. At that point, investors who held a traditional portfolio mix of 60% equity and 40% fixed income would have found themselves with a significant overweighting in fixed income. Using an annual calendar-year approach the investor would have simply left the portfolio as is and waited for December 31 to make changes. As a result, their under-weighting in stocks would have lessened their portfolio’s gain from the subsequent S&P 500 increase from 666 in March to 1,100 in November.
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