“The beauty of periodic rebalancing is that it forces you
to base your investing decisions on a simple, objective standard.”
— Benjamin Graham

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Benjamin Graham was a British-born American financial analyst, investor and professor often referred to as the “father of value investing,” and mentor of Warren Buffett.

Many of Graham’s views/strategies were focused on long-term investing based on financial fundamentals — and rejecting short-term speculation.

Much of his work was intended to take emotions out of investing, to be replaced by thorough mathematical analysis.

Buffett ascribes much of his investment success to these principles, and it’s hard to argue with that kind of success.

Which brings me to the concept of rebalancing a portfolio. Simple in concept, but surprisingly hard for so many folks to do in real life.

Here’s the deal. Let’s say you decided on a balanced portfolio — 60% stock and 40% bond — based on your long-term financial goals, time horizon and willingness to live with risk.

But the stock market has been tanking over the past several months — down 25% while bonds are up 8%. That means your portfolio is now about 45% stock/55% bond — way off from your plan.

What should you do?

• Do nothing — Let it ride and hope for a rebound.
• Buy more bonds — They’re looking pretty good these days.
• Get out of the stock market Before you lose even more.
• Sell some bonds/buy more stock — Get back to 60/40.

Now, let’s assume instead that the stock market is in a wonderful “bull market” with stocks up 25% while bonds are flat. That means the stock portion of your portfolio is now about 75% while the bond portion is just 25%.

What should you do if this happens?

• Do nothing — Let it ride.
• Buy more stock — Ride the bull.
• Get out of the bond market — It’s too boring.
• Sell some stock/buy more bonds — Get back to 60/40.

It’s hard to answer honestly in a theoretical situation without the emotions that come with the volatile markets that come with investing.

Research suggests that many investors choose options B or C as the “fear of being in”
(FOBI) or the “fear of missing out” (FOMO) causes them to do something they swore they would never do: buy high and sell low.

Cash flows into stock and bond markets clearly show this, so “someone” must be doing it. But it doesn’t have to be you, if you can be a disciplined investor.

This isn’t easy, and popular money cable TV shows don’t help with “talking heads” offering seemingly powerful arguments why “this time is different.” Be very afraid of those four words!

A prudent strategy is periodic rebalancing — as proposed by Graham. This system simply makes get your portfolio back to target levels — in my example, 60% stock/40% bond.

It forces you to do what your brain says makes sense — sell high and buy low — but something your emotions may find hard to swallow.

If stocks have enjoyed a nice ride up, take some profits off the table and buy more bonds that haven’t done as well lately.

If stocks have tanked, sell bonds to buy more stocks to get back to the 60% target.

Come on, you said you believe in buying low and selling high, so just do it.

This same discipline can be applied to portfolios that include both domestic and foreign stocks, emerging market stocks, REITs, etc. — periodically rebalancing each asset class back
to target levels.

Think this is crazy? Just think if you had bought more stocks the end of 2008 to rebalance after stock markets had tumbled more than 38%, and watched them rebound with a 29% return in 2009 and another 12% in 2010.

But doing this amid a very scary downturn with lots of awful economic news would have been tough, unless you had committed to rebalancing as part of your long-term investment strategy.

Note that research shows record net outflows of stock mutual funds in 2008-2009, clearly reflecting the fear of being in the stock market, with more and more stock sales the lower the market went.

This phenomenon is often referred to as “capitulation” as investors finally give up and sell — often at or near market lows. Only the most disciplined of investors “stuck with their plan” and thus enjoyed the rebound.

Buffett’s advice to “be fearful when others are greedy — and greedy when
others are fearful” is worth remembering.

So is his mentor, Benjamin Graham, and his advice about rebalancing.