In any investment portfolio, it’s normal to find that one asset class has outperformed the others in the recent past.
Our minds, being extrapolation machines, often assume that what has happened in the past will continue.
This can cause us to be drawn to investments that have performed well recently, hoping their strong performance will continue. The recent performance of parts of the US stock market is a good example of this.
This behaviour is unique to investing; in most other areas of life, we generally look for good value. We rush to the shops when there’s a sale, not when the price has recently increased.
In reality however, rather than recent price movements continuing forever, investment asset classes tend to “revert to the mean.”
Assets that have recently performed well go through a period of disappointing performance, while recent underperformers make a comeback.
To fight the natural urge to chase performance and take advantage of the market’s cycles, the disciplined investor has a secret weapon.
The Benefits of Rebalancing
When asset classes experience different returns, it’s normal for a diversified portfolio of shares and bonds to no longer align with the original investment strategy. This is where rebalancing comes into play.
Rather than being tempted to shift more assets into the performing asset class, rebalancing is periodically adjusting your investment portfolio to return to your target mix of assets. This means reducing the allocation to the asset class that has performed well and buying more of the asset class that has performed poorly.
While counterintuitive, it’s a powerful tool that can help counteract our natural impulses and keep our investment strategy on track.
When you rebalance, you sell some of the best-performing assets (which have become more expensive) and buy more underperforming assets (which have become relatively cheaper).
This systematic approach helps you capitalise on market fluctuations without trying to predict them.
Another significant benefit of rebalancing is ensuring your investments align with your financial goals and required return.
As markets shift and certain assets outperform others, your portfolio can drift away from your original target allocation. Regular rebalancing corrects this drift, keeping you on track with your investment strategy.
Lastly, in a world where short-term thinking often prevails, rebalancing encourages you to focus on your overall investment strategy.
It reminds you that investing is a long-term endeavour and helps you avoid reactive, emotion-driven decisions.
Discipline Triumphs Predictions
Successful investing is about consistency and discipline rather than trying to time the market perfectly.
The goal isn’t to predict which investments will perform best in the short term but to maintain a diversified portfolio aligned with your long-term goals.
By rebalancing, you’re positioning yourself to benefit when these trends reverse, as they often do over time.
The asset classes that have performed better are reduced in favour of asset classes that have underperformed.
In effect, the investor is “selling high and buying low.”
