Potential impact of rebalancing your investments (Photo credit should read MICHAEL BUHOLZER/AFP via … (+)
If you had to invest $10,000 of your cash savings into an investment vehicle today, what would you choose? There is no guaranteed right or wrong answer with the exact investment, but the strategy investors use when making this decision is where they can go wrong. Taking cognitive shortcuts or falling into common biases is human nature, but there are strategies that allow investors to avoid mindlessly joining the herd.
The bias of current market performance
The S&P 500 Communication Services Index has enjoyed a strong 2024, following a 56% gain in 2023. By comparison, the S&P 500 Information Technology Index, which enjoyed a 58% gain in 2023, has lagged slightly behind the Communication Services Index in 2024. However, both technology-heavy sectors have outperformed the broader S&P 500 in 2024 (as of this writing).
The macroeconomic analysis is that technology has dominated markets over the past few years, mainly due to the growing artificial intelligence (AI) revolution and the demand for tools such as semiconductor chips to power it.
After years in which only a few companies continued to drive the market higher, some retirement planners or investors may feel that this justifies a technology-only investment approach. However, are there legitimate economic reasons to invest in small and mid-sized companies, as well as other market sectors, when technology appears to be the primary driving force behind returns? Some investors argue that yes, the broader market makes more sense now, as they wonder whether the technological tide might be turning.
Other investors argue that it is not so much a case of a reversal in the tech sector, but rather that the time has finally come for the broader market to catch up with these rising sectors. For investors, this is known as a reversion to the mean.
A smartphone displays the stock price of NVIDIA Corporation on the NASDAQ market, with an NVIDIA … (+)
Reversion to the mean
Mean reversion, often attributed to the extensive teachings of 2013 Nobel laureate Eugene Fama and the principles of the efficient market hypothesis, refers to the idea that market prices and returns eventually gravitate toward their historical averages. In other words, when one part of the market gets hot for too long, it usually needs time to cool off, allowing less popular areas to have their moment of glory. The concept cautions against the need to time the market because it’s difficult to predict when a reversal will occur.
This phenomenon exists throughout the investment world. Take, for example, 401(k) mutual fund allocation. A common strategy employed by young, inexperienced people making decisions about their future retirement is the “what’s already been done right” approach—selecting stocks that have recently risen or funds that are doing well and assuming the gains will continue. Unfortunately, disappointing results often follow. The upward slope of these funds slows and the ignored ones pick up the pace. Perceived winners become losers. Simply put, what worked well before doesn’t always mean it will work well forever, and a reversion to the mean creates the opposite effect to that desired by the investor.
Mean reversion refers to the idea that market prices and returns eventually gravitate toward their … (+)
This phenomenon exists throughout the investment world. Take, for example, 401(k) mutual fund allocation. A common strategy employed by young, inexperienced people making decisions about their future retirement is the “what’s been done right” approach—selecting stocks that have recently risen or funds that are doing well and assuming the gains will continue. Unfortunately, disappointing results often follow. The upward slope of these funds slows, and the ignored ones pick up the pace. Perceived winners become losers. Simply put, what worked well before doesn’t work well forever, and a reversion to the mean creates the opposite effect to that desired by the investor.
Cognitive shortcuts
Seeking and valuing an asset simply because it has recently performed well is a common mistake. Most investors are not financial experts and the human mind tends to operate through a series of heuristics, or cognitive shortcuts, to simplify the decision-making process. The investor chooses the successful funds, based on an immediate and perceived practical solution. The world is too complex for an exhaustive analysis of every daily decision and heuristics are useful, even essential, to avoid mental paralysis. However, the drawback is that their use can lead to bias.
Recency bias
Recency bias is the tendency to put too much emphasis on recent events: seeing a news story about a plane crash and deciding that it’s not safe to fly. Similarly, investing in stocks or funds because they’ve recently boomed prioritizes short-term performance over long-term averages. Is there a chance this could work? Of course. But over time, recency bias can lead to poor decisions and problematic outcomes.
It can even lead to herding behavior, which British economist John Maynard Keynes viewed as a response to uncertainty and self-perceived ignorance. In other words, people may follow the crowd because they incorrectly assume that they are better informed. In financial markets, this type of behavior can lead to instability and speculative episodes such as the dotcom bubble.
Cognitive shortcuts, while useful, can create biases.
Confirmation bias
Confirmation bias is the propensity to seek out, interpret, and recall information that corroborates prior beliefs. For example, someone who believes semiconductors are the new gold might seek out similar opinions and then cite those sources as evidence.
This trend relates again to the investor who focuses on what has already been done well. Instead of making balanced decisions based on long-term historical trends, this person focuses on a six-month winning streak.
Rebalancing the bottom line
In today’s market, it’s tempting to abandon non-tech stocks, but that strategy may be short-sighted. Market history points to a likely mean reversion, leading to profitable rallies in other segments of the investment landscape.
One way to combat bias is to rebalance investments: sell a portion of the best-performing sectors and reinvest in the worst-performing ones to restore a more balanced allocation of stocks. Selling at high prices and buying at low prices counteracts the natural human impulse to chase recent winners.
One way to combat bias is to rebalance.
While it’s difficult to quantify the precise impact of rebalancing on overall returns, its value lies in practicing disciplined, long-term investing. By consistently adjusting your portfolio to help maintain symmetry, you could not only spread risk, but also take advantage of market inefficiencies, buying undervalued sectors and selling overvalued ones. Currently, the potential for rebalancing seems most relevant when looking at technology stocks versus utilities. Still, it could also apply when considering stocks versus bonds, large-caps versus small-caps, and many other market scenarios.
The impulse to join the herd and stampede towards the current trends is natural and human, but not … (+)
The impulse to join the crowd and stampede toward immediate trends is natural and human, but it is not necessarily always productive for investing. Rebalancing can help people resist following the crowd and instead focus on maintaining a well-diversified and balanced portfolio that has helped build enough savings for many happy retirees.
Rebalancing can help maintain investment diversification within a long-term retirement plan.
This information is provided to you as a resource for informational purposes only and should not be considered investment advice or recommendations. Investing involves risks, including possible loss of principal. No guarantee is made that a return, profitability or return on investment will be achieved. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors or general market conditions. For stocks that pay dividends, dividends are not guaranteed and may increase, decrease or be eliminated without notice. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates increase, the value of fixed-income securities decreases. Past performance is not indicative of future results when considering any investment vehicle. This information is presented without regard to the investment objectives, risk tolerance or financial circumstances of any specific investor and may not be suitable for all investors. There are many aspects and criteria that should be examined and considered before investing. Investment decisions should not be made solely on the basis of the information contained in this article. This information is not intended to, and should not, form the primary basis for any investment decision you may make. Always consult your own legal, tax or investment advisor before making any investment, tax, estate or financial planning decisions or considerations. The information contained in the article is strictly an opinion and it is not known whether the strategies will be successful. The opinions and views expressed are for educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors such as market or other conditions.
