Rebalancing - using new cash or shifting money to bring your investment portfolio's target allocations back in line annually - is one of the simplest and soundest investment strategies around. This, of course, supposes that you're following some sort of asset allocation policy to begin with.
In this letter we will try to help you develop an understanding of the benefits in having an asset allocation policy and how this simple advice can improve your chances for success when making investment decisions.
Let's say that you've already come to the realization that asset allocation is the most important portfolio decision you can make. Let's go one further and say that you've already consciously settled on target percentages for stocks and other investments. Congratulate yourself! You are several steps ahead of most individual investors.
Now, are you also aware that you should be periodically rebalancing your portfolio allocations? Unfortunately, too many investors don't. Some chalk it up to ignorance, forgetfulness or laziness, but it's more than likely just human nature. After rotten years, many investors tend to lick their wounds and pay less attention to their investments. Or after a super year, one might figure, why fix what isn't broken?
Here's why: When you rebalance annually, you build discipline into your investment plan, adding money to laggards and shaving shares of leaders. This boils down to buying low and selling high, while also helping you avoid the natural but wrong-headed tendency to chase performance.
Rebalancing is one of the few free lunches out there. Why is it? Because, you're generally selling things that have gone up the most and buying things that have gone down the most. Someone who doesn't rebalance is likely to fall victim to the 'small investor theory'.
As the theory goes, a 'small investor' buys ' purchases investment assets ' when prices are high and sells when prices are low. This is because the 'small investor' is more likely to follow the crowd rather than follow a disciplined approach. They invest when they hear of the successful experiences of friends and neighbors 'usually after a significant run up in the market' and sell when they hear that market prices are falling. This is the parenthetical opposite of what investors need do to create wealth ? to do so, one needs to buy low and sell high.