Psychologically, all investors, including professionals, are prone to using simplistic “rules of thumb”, or decision-making biases when deciding when to buy or sell a given asset. Some of the biases are involuntary, subconscious, and very difficult to identify by self analysis. We sometimes make irrational decisions that we are unable to recognize as irrational because they “feel” right.
Have you known someone whose investment habit is to careen from idea to idea based on the headline news of the day? Do you have friends who cash-out their investments at the first sign of trouble, only to return to markets later when the coast appears to be clear, (i.e. when prices are higher than when they sold)? If so, you are witnessing a qualitative approach to investing. I call this “gut feeling” investing. Alternatives to this management-by-guessing approach, are quantitative, or mathematical methodologies.
The first step in a quantitative approach is to spread one’s assets across multiple asset classes, this is known as “asset allocation”. Once one’s assets are allocated appropriately to balance risk and reward according to the person’s goal, and time to work toward that goal (a science in itself), one then needs a method of keeping in balance so that risks are not allowed to build uncontrollably with the passage of time. It is here that the potential for psychological biases to invade a good plan is a risk. That is, it is possible to build a portfolio scientifically in the beginning, but then use a gut-feeling approach to determine when to re-balance, or allow feelings to dictate changes in the allocation policy itself in reaction to environmental events.
I employ a quantitative approach I call “Range Rebalancing”. This is a method of account management whereby an accepted percentage range is assigned to each asset class in a portfolio. Asset values in each category are allowed to “float” within a pre-specified range from the initial target allocation. When an asset category moves in value beyond a “re-balance trigger”, then an appropriate amount of that asset will be purchased or sold only to the degree necessary to bring the category back to within a tighter range of the original target percentage known as the “tolerance band”. This is money management by policy, rather than feelings.
No strategy assures success or protects against loss.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not ensure a profit or protect against loss.