Tags: investing June 26, 2008    

A common approach to investing is to be diversified by rebalancing a portfolio or using index funds, which automatically rebalance over time.

Although the core idea is probably good, there is a problem. Selling an investment that will go up or buying an investment that will go down to keep a portfolio balanced reduces returns.

I'll illustrate my point with an example.

Two investments start at $100. The first goes up 400% to $500, the other stays flat at $100.

Then the portfolio is rebalanced by selling $200 of the first investment and buying $200 of the second.

However, because of momentum, the first investment increases by 400% again and the second investment stays flat. The end result is that the first investment is $1500 and the second is $300 for a total of $1800.

What would have happened without rebalancing? The first investment would be worth $2500 and the second would be $100, for a total of $2600.

Although the return is good, it could have been better.

A similar scenario arises when prices of one investment go down relative to another.

In my opinion diversification is good, since that way chances are part of the portfolio will do well. However, rebalancing should not be done at any point in time just to have a balanced portfolio. Rather rebalancing should be done when the conditions are appropriate.

Copyright © 2008 Borys Bradel. All rights reserved. This post is only my possibly incorrect opinion.