The Power Of Balancing – Why It Works

tightrope dog

Stocks are at an all time high. Yet pessimism is also at an all time high. “Shouldn’t I wait for the market to crash before buying?” That’s a very popular question that I get asked all the time. So what if the market doesn’t crash for another 3 years and the market goes up another 30%? Do you miss out on all the gains in the mean time?

Timing the market has never been a good method for normal investors. That’s because we’re emotional and buy when the market is high but sell when the market tanks. Many young investors today, if there are any at all, haven’t experienced a major downturn in the market in the last 9 years. The current string of gains have probably made many people overconfident of their abilities. But it’s not how much one makes during the good years that matter, but how well one preserves during the bad years.

Missing The Good Ole Days

Most people stay on the sidelines because they don’t want to enter the market when it crashes. It’s probably the most disheartening when an investor puts money into an investment and during the first year it losses 20%. That money was really hard to save! That might have been 4 months of savings!

On the flip side of the argument is that not being in the markets for its best days can be just as damaging to the growth of the investment:

best days

Missing good days over the course of many years can lead to a drastic drop in the expected rate of return. When do these days occur? No one knows. That’s the problem with timing the market and sitting on the sideline. Being fearful or complacent can lead to missed gains and most likely regret of never taking action to begin with. Does that sound like you?

Portfolio Balancing

So how can this fear of losing money on the marketplace be overcome? How can an investor feel comfortable in taking the plunge when there is always a fear of a correction in the market?

That’s where balancing a portfolio matters. By having a good diversified portfolio to begin with, it makes it much easier to weather the storm when it eventually hits. Being diversified is important, because without any diversification, the whole balancing strategy doesn’t work. There is nothing to balance when the entire investment portfolio is made up of a single weed stock that goes up in smoke!

A standard issue balanced portfolio should look like something that you can find on the Couch Potato website.

  • 20% Canadian equity
  • 20% US equity
  • 20% International equity
  • 40% Bonds

A good mix of equities in different regions of the world gives coverage across different sectors in the economy. Canada is predominantly banks and resources like gold, oil and lumber. The US economy is much more broad and consist of consumer product, technology, financial, resource and health Care companies. By investing in international markets it gives exposure to faster growing countries like China, India and South Korea. These countries offer higher risk but also their populations are much bigger and greater chance for growth. Bonds are necessary because they act as a damper for stocks. Remember that bonds generally move in the opposite direction of stocks. When stocks go up bonds go down. When stocks go down, bonds go up. Bonds are what allows investors to stomach the wild ride of the stock market. It’s like driving a car with seat belts. You never want to start without them.

If an investor has a balanced portfolio to begin with, then it’s possible to readjust it during good and bad times to help smooth out the gains and drops. Take for instance this first case where an investment portfolio can’t be rebalanced because it’s not diversified and only consists of Canadian stocks.

CanadaOnly

You’ll notice that the initial drop in 2008 would be extremely big. In fact most investors would probably get scared and sell for a loss greater than 30% and vow never to invest in the stock market ever again. Those that stuck through it might have recovered, but that’s just hypothetical. So what happens when you have a diversified portfolio but don’t rebalance:

DiversifiedNotRebalanced

In this case, the drop in 2008 isn’t too bad at all. It’s less than 20%. On top of that in 2011 when the Canadian markets went down again, this portfolio stayed in the positive. That’s the power of diversification. It “smooths” everything out.

So let’s incorporate rebalancing a diversified portfolio:

DiversifiedRebalanced.png

Alright. In this case we see that the drop was a bit bigger in 2018, but the recovery was a little bit better. By rebalancing, what’s happening is that the total amount is then redistributed into the 20% Canada, 20% US, 20% International and 40% Bonds each year. By doing this an investor is automatically practicing the habit of selling high and buying low. This is important because it is used to lower risk and mitigate the wild ups and downs that investors can’t get sleep over. What this robot like behaviour is doing is taking away the emotional aspect from investing.

Start Today!

What does this all mean? It means that as an investor, one should never be trying to time the market. It doesn’t work because no one knows when a crash will happen, and no one knows when the market will rise. The only thing we can do as investors is to stay the course and continually rebalance the investment portfolio.

Make sure there are enough variations in investment types to reduce volatility and risk. Remember to always have bonds as bonds are there to put the brakes on a portfolio that is running away due to a bubble stock market and also to cushion a fall in the case of a crash. Think speed regulator and airbag. If you can plan for accidents in a car, why not do the same for an investment portfolio?

Don’t worry about all the Yahoo articles speculating the next big crash. The fear mongering is there to sell news. No one reports good news. It’s just plain boring. But if you can predict a crash coming up, eventually it will come true and the news wire can claim “I told you so”.

In this day and age with so much “Fake News”, it’s best to just ignore it. Control what you can control and that’s your own investment portfolio. Take charge of your own money, because no one is going to look out for you but yourself. And maybe this blog. So keep reading and get investing!

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