During a market downturn, the most important thing to do is to stay invested. If we do nothing else, we will emerge victoriously. But by also rebalancing our portfolios, we’ll give ourselves an edge when the market snaps back.
During a crisis and a big downturn, everyone sells risky investments like stocks and buys safe investments like bonds. This drives stock prices lower than normal and bond prices higher than normal.
After humanity wins the day, stock and bond prices will return to their natural resting state. Bonds will be sold – driving prices lower. Stocks will be purchased – driving prices higher. (For the nerds: this is called mean reversion.)
So during market downturns, we can give ourselves an edge by selling bonds while their price is temporarily inflated and using the proceeds to buy stocks while they’re on sale.
And when things go back to normal, we’ll own less of the investment that will drop – bonds – and own more of the investment that will pop – stocks.
This is easier said than done. The whole world is swimming one direction – selling stocks and buying bonds – and we’re swimming the other way – selling bonds and buying stocks.
And not only are you swimming in the opposite direction, you are also doubling down on the part of your portfolio that’s caused you the most pain recently.
But like Warren Buffet famously said “Be fearful when others are greedy and greedy when others are fearful.”
This process is called rebalancing because you’re rebalancing your portfolio allocation.
If your portfolio is normally 80% stocks and 20% bonds, during a downturn it might become 70/30 as stock prices fall and bonds prices rise. Left alone, it will eventually return to 80/20 when things return to normal.
By rebalancing, we don’t wait for it to happen by itself. Instead we’re taking advantage of this temporary pricing discrepancy.
So we sell the extra 10% in bonds (locking in those gains) and use it to buy 10% more stocks (before they rebound). Now we’re back to our target 80/20 allocation.
Times of crisis and market downturns put us in heightened emotional states. Having an investment strategy in place can prevent us from making impulsive, emotional decisions like selling everything or swimming with the crowd.
As part of that investment strategy, rebalancing will give you the edge when the world goes back to normal.