How is rebalancing different from market timing?

Rebalancing is simply the process of selling a portion of your overweighted investments, and using the proceeds to buy more of your underweighted investments. This is an important part of the ongoing management of your portfolio. Effectively, it forces you to sell the asset class that has been performing best and buy the one that has been performing worst. And you are going to pay transaction costs for the pleasure of doing so. Not an easy thing to do psychologically. Did I mention that, unless this is in a tax-sheltered account, you will also likely incur taxes in the process?

Given all this, why bother? Shouldn’t well enough be left alone?This is a common sentiment by investors following periods of rising stock prices.  The enjoyment of seeing your portfolio value rise begins to overshadow the feelings of fear that we will have another market decline.  In the face of this, some investors are tempted to let the portfolio ride.  They avoid rebalancing to avoid the possible regret that they might experience if the market were to continue to rise.

Investor’s emotions certainly play a role in rebalancing anytime markets have moved significantly up or down.  The right thing to do in the depths of the market downturn was to sell bonds and buy more stocks.  Emotionally, that was difficult to do.  Think back to the headlines in late 2008 and early 2009.  We were in the midst of the greatest financial crisis since the Great Depression, and no end was in sight.  Many investors were tempted to ditch the markets entirely and stick whatever was left under the mattress.  Yet the right thing to do was not only hold your stocks, but sell part of your bonds to buy more stocks!

And now, after a period of rising stock prices, the opposite is true.  After a period of strong performance of stocks, sound rebalancing policy likely calls for you to sell the best performing asset classes and buy the worst performing ones.  Right now, that likely means selling U.S. stocks and buying bonds or Emerging Market stocks.

But isn't that market timing?  The short answer is no, not if you are systematically rebalancing.  Think about it like this.  Let's say you have simplified portfolio with a 60/40 target mix of stocks to bonds, and stocks do well causing your portfolio to look more like 70/30.  By allowing the portfolio to remain overweighted in stocks, you are leaving your portfolio exposed to greater risk in the event that stocks subsequently decline.Rebalancing often feels like market timing to investors.  Due to recent performance, you’re selling part of one asset class to buy more of another asset class.  Sounds like market timing to me.  In fact, just the opposite is true.  If your portfolio warrants rebalancing because of recent market movement, making the decision NOT to rebalance is basically market timing.

Here’s why: if stocks are overweighted relative to your target allocation, opting to continue to hold the overweighted positions is a decision to violate your investment policy.  Why would you make that decision?  Typically, it’s because you believe that the recent strong performance of that asset class (in this case, U.S. stocks) will continue relative to other asset classes.  This is the very definition of market timing: altering allocation across asset classes based on a prediction of future returns.