Investors find many ingenious ways to underperform stock indexes. Sadly, many have no idea that their brilliant moves actually work out badly over time because they don’t track their returns accurately. Among the ways that investors manage to harm their portfolios is what I call “anti-rebalancing”.
The idea of rebalancing your portfolio is that you start will fixed percentages of various asset classes, and when they drift away from the fixed percentages, you bring them back in line. For example, suppose Beth holds 4 funds in equal amounts: Canadian stocks, U.S. stocks, foreign stocks, and bonds. Every so often she checks which fund balance is higher than the others and which are lower, and she makes some trades to get the amounts back in balance.
This sounds easy enough in theory, but isn’t so easy in reality. After the explosion of U.S. stocks in 2013 and the relative underperformance of foreign stocks, Beth is supposed to sell some of her U.S. stock fund and buy more of her foreign stock fund and bond fund. It can be hard to make the decision to sell your best performer and buy the dogs.
This brings us to what I see some investors do: anti-rebalancing. They sell some of their dog funds and buy more of their top performers. This can actually work out well sometimes. Maybe U.S. stocks will shine again in 2014. Unfortunately, over time, anti-rebalancing works out worse than rebalancing. This is because rebalancing amounts to buy low and sell high, which anti-rebalancing amounts to buy high and sell low.
Few investors think of their strategy as anti-rebalancing, though. They offer intelligent-sounding reasons why their allocation percentages need to change. Maybe they decide the sentiment that the U.S. is losing its place of world dominance is overblown and they should keep a sizable portion of their savings in U.S. stocks. Whatever the reasoning offered, the bottom line is that they pour more money into whichever fund is up the most.
If you think of yourself as an index investor, but you make your own judgements about portfolio changes instead of simple rebalancing, I urge you to look over your history of trades and see what would have happened if you had rebalanced mechanically. The majority of investors who do this exercise honestly will find that their trades have actually hurt their returns.