Rebalancing vs. Trend Following

The investing world is full of tortoises and hares. Tortoises swear that slow and steady wins the race. Hares claim they can outpace the market. You can create a balanced portfolio designed to give you steady gains, or you can jump on market trends as they develop. It pays to understand the criteria behind constantly rebalancing or moving in and out of the market when you see extraordinary opportunities.

Rebalancing Advantages

When investors create balanced portfolios, they make broad choices between stocks and bonds, as well as real estate and commodities such as gold and oil. Investors make these choices based on historical trends in the markets. For example, in an article by Steve Santiago in Bankrate.com, he quotes Judith Ward, a senior financial planner at T. Rowe Price, as saying that there has never been a 15-year period when stocks had an average negative return. This leads many investors to maintain a position in stocks at all times, with a percentage of their portfolios invested elsewhere. Bankrate suggests that investors subtract their age from 100 and put that percentage in stocks, with the rest in bonds and other investments. This means at age 40, an investor would have 60 percent in stocks and 40 percent in non-stock investments. If stocks do particularly well, the investor could rebalance by selling some stocks to keep the percentages he has set. This offers the advantage of safety, because if stocks start performing poorly, the rebalanced portfolio will have the remaining 40 percent invested elsewhere to produce income or make a profit.

Rebalancing Disadvantages

Investors may miss some opportunities as a result of rebalancing. For example, if stocks do well and the investor sells a portion to maintain the stock percentage she is aiming for, she may sell stocks that could have made her profits. In addition, she may put the proceeds from the stock sale into investments that go down in value. In other words, investors who maintain their portfolio percentages no matter what the market tells them may become too detached from economic developments that can affect their portfolios.

Trend-Following Advantages

When investors spot a favorable trend and put their money into it, they can make profits that beat the market averages. Then when they see the end of the trend and pull their money out, they can protect their money from losses. This approach can help an investor eliminate much of the risk in the market, because money doesn’t stay in an investment when it is losing. The idea behind this approach is that a trend has momentum until something happens to stop it. In other words, if a stock is headed up, it will continue to do so until some news comes out that makes it unattractive or until investors start taking profits and selling it off.

Trend-Following Disadvantages

Trend followers can miss out on the market’s best days. Eric Dutram, writing for Seeking Alpha, says that from July 1, 1982 to June 29, 2007, if an investor had missed the 10 best days the stock market had, she would have missed out on more than $30,000 profit from an original $10,000 investment. A trend follower might not have been in the market on those days; Dutram points out that it is extremely unlikely that a trader would nail the best 10 days in a 25-year period. In addition, trend followers pay a lot of trading fees because of the constant buying and selling. This can eat into profits. Trend followers also may have to pay short-term gains taxes, which are much higher than those for people who hold their stocks for one year or more.