Portfolio Rebalancing and Buying Underperforming Assets

Question

This question is in reference to my prior article, Everything You Ever Wanted To Know About Asset Allocation.  The question is about how an investment portfolio can become unbalanced and why should you buy more underperforming assets.  Here is Botong’s question:

Hi, I was just reading your article on asset allocation, and I don’t understand this paragraph.

This is where the magic happens with asset allocation. When your allocation shifted from it’s original percentage, you are selling some of the assets that  have been doing well and use that proceed to buy more shares of assets that have been underperforming to restore the original percentages. This is basically a “buy low, sell high” technique.

Two questions:

  1. How does the portfolio become unbalanced in the first place?
  2. Why buy more underperforming stock? How do you know they will regain performance?

Thank you,

Botong

Answers

Here’s a response from Mrs. Micah:

Great questions. 1) The portfolio becomes unbalanced when one asset outperforms all the others. Suppose that I have a very simplistic asset allocation of 50% stocks and 50% bonds. In the last year, let’s say that my bonds did decently but my stocks crashed. Now when you look at the overall money in my investing account, 70% of it is in bonds and 30% is in stocks (bonds didn’t increase by 20%, but I have less money overall such that that the original 50% plus its earnings now represents 70% of my total portfolio).

2) It’s important to distinguish between underperforming assets (individual stocks and bonds) and their asset classes. This was a bad year for stocks, mutual funds, and index funds. Does that mean that you shouldn’t ever buy them again? No. In other years, stocks and funds have brought in great returns, the market is cyclical that way. Buying more while the class is underperforming is actually the buy low part of the “buy low, sell high” goal that most investors have (or buy low, hold forever, sell higher).

In a year when stocks are a runaway success, it’s also important to rebalance periodically. That way, you don’t end up with 80% in stocks and 20% in bonds in a year like this one.

When it comes to underperforming individual assets (stocks, specific funds, etc), you shouldn’t throw good money after bad by buying more. Just because you invested in them before doesn’t mean that it’s a good idea to continue investing in those particular ones. You have to re-evaluate them the same way you did when you first bought them before you buy any more shares.

Here’s a response from Patrick at Cash Money Life:

Mrs. Micah hit the nail on the head, especially regarding why the portfolio became unbalanced in the first place. The various parts of the market rarely move at the same pace, so a balanced portfolio is bound to become an unbalanced portfolio over time.

Regarding your second question, “Why buy more underperforming stock? How do you know they will regain
performance?” the answer depends. Underperforming may mean “undervalued,” or it may mean “Bad! Stay away!”

The key to this is to look at the investment as if it were a new investment. Would you put money in it now if you didn’t already have money in it? Do you see value in the investment? This may be a difficult question to answer if you are investing in individual stocks, but if you are investing in an index fund, then you may just be buying the entire market at a discount. Even though the market is down roughly 40% over the last few months, now may be a good time to invest — so long as you are investing with a long term goal.

Here’s a response from Plonkee at Plonkee Money:

Yep, everything Mrs Micah said is right, and then Patrick.

Usually, your asset allocation doesn’t allocate assets to individual stocks/funds — that’s generally where the good money after bad comes in. But in general, if stocks are cheap now they’ll be expensive in the future and so on, and you want to try and maintain a certain asset allocation. At your stage your desired asset allocation for retirement investments shouldn’t change much over say 5 years.

About the Author

By , on Jan 26, 2009
The following is a question submitted by our reader. You can see all questions submitted here, and submit your question here. Please remember that our answers are opinions and should not be considered professional advice and we assume no responsibility of any kind. Please consult a financial expert as needed.

Leave Your Comment (4 Comments)

  1. Pinyo says:

    @Steve – I hope things start to pick up soon. It is rather slippery on Wall Street at this point.

  2. Steve says:

    Hello, Pinyo, I thankfully went through the process of rebalacing my portfolio at the beginning of the year. On the one hand, it was sad to see lower balances, but on the other hand, it was good to feel secure as I head into another year of investing. It’s good to keep buying when blood is running in the streets, as some famous investor once said. In other words, keep investing, especially when fear is rampant, because that is the best time to pick up low deals on equities.

  3. I agree with the statements above. I do re-balancing every year during spring cleaning. One of the big things for me is to clean out my bank stock. I work for a bank and some of their 401k match is in company stock. All the banks did awfully last year. I also has a fund holding some bonds that outpaced my stock indexes, so a rebalance is in order. Some will recommend rebalancing every 6 months, but I think annually is perfectly fine. Great post!

    • Pinyo says:

      @Weakonomist – Nice add about how some companies are matching with the company stocks. I’d definitely trade them out for other funds. My rule is no more than 5% in company stocks, and my current holding is 0%. I think I am holding enough of my company through U.S. Large Cap Fund.

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