A responsible version of market-timing

I recently saw this E-Trade commercial. It begins in an auction room where bidders are looking to buy different types of dips—like French onion and spinach and artichoke (I prefer the former). E-Trade jokes that if you think dips are food related and not investment related, maybe trading isn't for you. Though the commercial is tongue-in-cheek, it may prompt investors to think about "buying the dip," or buying investments when prices are down.

What is market-timing?

This got me thinking about market-timing, the practice of trying to predict future market prices and buying or selling accordingly. The goal, of course, is to buy low and sell high. But individual investors aren't great at this. Predicting when an investment or asset class will go up or down is hard enough for professional investors, let alone individuals building their savings.

Human biases like recency bias or herd mentality can cause poor market-timing. News of certain stocks performing well may lead some investors to chase their returns just as these stocks may be headed for a downturn. This can cause investors to buy high and sell low.

However, there is a way to time the market, in a sense, with a view to long-term performance. It involves rebalancing your portfolio.

What is rebalancing?

Rebalancing your portfolio means returning your investments to your preferred asset allocation. For example, say you want your savings composed of 90 per cent stocks and 10 per cent bonds. If stocks performed well over the course of a year and bonds did poorly, at the end of the year that allocation may have drifted to 95 per cent stocks and 5 per cent bonds.

To rebalance your portfolio, you'll need to sell some stocks and buy some bonds, which can be considered a responsible way to time the market. If stocks had done well that year, selling them means cutting back on stocks when they were hottest. If you're buying bonds after poor performance, you're buying low. This improves your chances of meeting your long-term goals.

It's also important to rebalance regularly. Morningstar portfolio strategist Amy Arnott explains how annual rebalancing is effective for most investors—as it requires less work and offers less volatility. Daily rebalancing offers higher returns with only slightly more risk than annual rebalancing, but this strategy's time commitment isn't practical for most investors.

Staying the course

Behind the message of responsibly timing the market through rebalancing is the idea of "staying the course". Staying the course means buying and holding your investments for the long term, while staying true to an appropriate asset allocation. Periods of market downturns may tempt investors to sell their investments to avoid further loss.

However, holding stocks through losses—and even adding to the stake by rebalancing periodically—allows investors to participate in a stock market recovery.

 See also Morningstar Guide to International Investing