Rebalancing the allocation among risky assets in your investment portfolio is an important discipline. It provides a structured way to maintain consistent risk exposure over time and forces us to “buy low and sell high” when it is not always the comfortable thing to do. This quarter is a good example, in the midst of crashing stock prices, and record volatility in markets, we have been selling bonds to buy stocks in our portfolios. Buying stocks during all this uncertainty can feel uncomfortable if not downright frightening, but here are a couple of things to keep in mind.
Cash never “goes to the sidelines.” If you listen to the talking heads of financial news-media, it can sound like all investors are reducing their exposure to stocks, and hoarding cash to buy back in when prices are lower. But that’s not the way markets work! Whenever a share of stock is sold, another investor buys it. When there are more sellers than buyers, prices fall to clear the market. Warren Buffet’s famous saying bears repeating now, “Be fearful when others are greedy, and be greedy only when others are fearful.” Another famous quote strikes a chord as well, “In bear markets, stocks return to their rightful owners.” Long-term investors want to be the owners of stocks and down markets are an opportune time to buy.
When stock prices drop, expected returns increase. It may at first seem counterintuitive, but the math is fairly straightforward. The value of a stock, or any other asset, can be described as the discounted present value of all future cash flows. There are two factors that influence the value of a stock: future cash flows and the discount rate. When cash flows become more uncertain, we apply a higher discount rate. Logically, a rational investor would pay less for an uncertain stream of cash flows than a stream with greater certainty. The discount rate is a reflection of expected returns. When risk and uncertainty increase, investors demand a higher expected return. Over the past two months many stocks have decreased in value by 30% or more. Some of the decrease in value is driven by an expectation of lost revenue and profits (future cash flows) resulting from Coronavirus’ shutdown of the global economy. However, some of the decline is due to fear and uncertainty, which translates to a higher discount rate. Both of which have a negative impact on stock valuations. In turn, buying stocks at today’s prices comes with the expectation of higher rates as compared to two months ago.
Rebalancing is a valuable and important discipline. If you still have questions about rebalancing, or worry about the appropriateness of your target allocation, talk to your advisor.