While rebalancing forces us investors to comply with our stated investment policy, it also forces us to sell those asset classes that are performing the best. This is extremely difficult for most individual investors, and a brief review of behavioral finance shows why.
Overconfidence, belief perseverance and availability bias are among the various characteristics described by behavioral finance theory that may affect rebalancing decisions. Overconfidence leads us to ascribe success to our own talent. Research shows that when people are asked to assess their own skills in particular areas, 90 percent of respondents rank t h e m s e l v e s âabove average.â.
Studies in belief perseverance provide evidence that we form an opinion and cling to it too long, often in the face of data that directly contradicts their beliefs. Further research shows that when confronted with contradictory evidence, we contort it to support our views. Belief perseverance also explains how we investors become un-diversified -we select our investments based on what has performed well recently.
Availability bias suggests that recent events, especially noteworthy ones, shape our views on what to expect next. The result is that we investors extrapolate experiences of the recent past, whether good or poor, far into the future.
Disciplined portfolio rebalancing reduces the bias of these beliefs by causing us investors to stay focused on our (stated) investment policy rather than the emotion of recent successes or failures.
Let’s discuss what has worked/not worked for us in the past & why. References to the recent past of Dec 2007/Jan 2008 and the experience thereafter may provide us important insights.
No one strategy is right or wrong for me, its also about my personal situation, my temperament and my individual risk tolerance. For example riding out whole of 2008 into 2009 May entirely on a small cap portfolio, remaining 80% invested, may not be my cup of tea. I know it has worked very well for some astute valuepickrs right here in this community, hope some of you will speak up for the benefit of us all.
I remained invested 100% (not knowing better :-)) largely on a large cap dominated portfolio initiated in 2005 crash and remained unscathed and doing very well now, thank you; but rued the fact that there was such a big opportunity cost to be paid - I could only marginally bet at the extreme lows in Feb/Mar 2009; my research/homework was done, the cash was all tied up; most of my trader friends made a big killing then, while I sat twiddling thumbs!
So please also try to share why it worked for you as an individual and your stock picking style, and what did not too.
Cheers!
Donald