Imaginary Profit and Rebalancing

There is a grievous evil that I have seen under the sun: riches were kept by their owner to his hurt, and those riches were lost in a bad venture. — Ecclesiastes 5:13-14b (ESV)

Have you made money in the stock market over the last couple of years? Or even the last 10 years? It’s worth thinking hard about taking some profit now. Even selling a tiny amount, say 10-15%, will help you feel better in the event of a drop. And if that 10-15% goes into an asset which tends to go up when stocks go down—gold is the best example—then you will feel much, much better. Profit that’s still locked up in the stock market is imaginary. It isn’t real until it is cash in hand or in the bank.

net_worth_bubble

This graph (from this article) compares US households’ net worth to US GDP. It is pretty sobering: household net worth (house, stocks, bonds, gold, etc.) has drastically outpaced the real economy. Conditions were similar during the dot.com and housing booms. Eventually economic gravity will have its way and we will see a drop, or even a crash, in stock prices. (There were some negative days earlier this month, but those were relatively minor, and the markets rebounded.) Again, if you sell some stock now, you will be financially and psychologically better prepared to face falling markets in the future.

Rebalancing should be easy and automatic

This is sometimes called rebalancing: periodically sell some assets (the ones that have gone up in price) to buy others (those which have been flat or decreased recently). It is the bare minimum action which still provides protection from crashes/bubbles. I have done a lot of simulations with and without rebalancing (under random market conditions) and the rebalanced portfolios almost always perform better.

Despite working nearly full-time on trading/economics in the past year, probably 50-70% of my trading decisions were easy and automatic. They were triggered by the need to rebalance. My portfolio sometimes got really heavy on one side (due to price gains) or light on one side (due to price crashes). By rebalancing in these cases I automatically sold expensive assets and bought relatively cheap assets.

The middle class pays the bill

I wanted to write about this because in the past few weeks I’ve seen more and more articles which point out that institutional investors are starting to sell stock. There are 3 main categories of investors:

  1. Governments – For example, the federal reserve sometimes buys assets on the market, usually using freshly printed money.
  2. Institutions – Big investment banks like Goldman Sachs, centrally managed pension funds, university endowments, hedge funds.
  3. Retail investors – This is a euphemism for the “Middle Class.” People like you and me.

Guess what? Retail investors almost always do worse than institutions in the buying and selling cycle. Over the past 10 years, with stocks starting out very cheap (2008) and gradually becoming more expensive, the buying trend started with government and then institutions. They got the stock at the cheapest, post-crash, prices. Many Americans started buying after prices increased significantly. And now that the stock market is close to all time highs, retail buying is still increasing. When the government and big banks start getting out, they stick the middle class with the bill. The “bill” in this case being overpriced stocks.

Common barriers to rebalancing

Depending on where your investments are held, all your investment decisions might pass through a gatekeeper. This could be an employee of Edward Jones or other financial advisor. That person unlikely to recommend that you sell or otherwise rebalance your portfolio. You may even have to fight them to do what you want with your own money. This is what I experienced when I started taking control of my own investments a couple years ago. If that happens to you, it might be time to fire that person and take your business elsewhere.

Even worse, rebalancing when stuck with Edward Jones or similar “advisors” will result in extra fees. Each time you buy they will charge you several percent of the amount invested! Instead, open a Vanguard account. Anything you sell now, rebalance into that Vanguard account. Purchasing funds from Vanguard is free, compared to the 2-6% fee many other places charge.

Step-by-step

To summarize, these are the steps worth considering:

  1. Open a Vanguard account
  2. Sell some overpriced assets (in this case stocks)
  3. Transfer that cash to Vanguard
  4. Buy something anti-correlated with what you sold. (For example, if you sold stocks a gold ETF like GLD might be a good choice.)

I am not a financial advisor and this is not investment advice. Each person’s financial situation is different and only you know your own situation. Do your own research and make an informed decision.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s