by Archie M. Richards, Jr.
October 8, 2007

Jeff writes, "Why do so many advisors advocate rebalancing? It has never made sense to me. If I had two farms, one a good producer and the other a poor producer, I wouldn't sell the good land and buy more of the bad. Instead, the sale should involve the perceived value of the underlying asset."

Your example leaves out a crucial factor, Jeff: price. If you could sell good land for $5,000 an acre and buy poor land for only $1,000 an acre, you could spend $2,000 an acre raising the quality of the poor land and still come out ahead.

With farmland, you can be reasonably sure of the value. You evaluate the soil, drainage, temperature, rainfall, and other factors and form a good idea of what you're buying. So it is with anything tangible.

But intangibles, where there's nothing to touch, are different. Oh, you can visit a company's headquarters and wrap your arms around the front door. But you'll learn nothing about the company's earnings potential. You might get to talk with an executive, but federal law prevents her from predicting the future for your benefit. Even professional stock analysts are often way off in their earnings predictions.

Even more conjectural is the future price-earnings ratio. Let's say you're right about the future earnings - assume $1 a share. But neither you nor the professional analyst has any idea whether the market will set the stock price at 10 times earnings ($10), 20 times earnings ($20), or some other number. Everything about a stock - and the stock market - is uncertain.

To repeat, with tangibles like farmland, you can do a pretty good job of calculating "the perceived value of the underlying asset," as you express it. But with financial intangibles, you're swimming in the dark.

It may not seem as if you're swimming in the dark. All of us pick up items of interest from TV, newspapers, and magazines. But when the news induces us to buy or sell stocks, we often prove wrong. The market is counterintuitive. Our intuitions tell us that on the basis of certain news, stocks should go in a certain direction. But they don't; all too often, they go the other way.

Here's why: The market is acting according to news that no one yet knows about. The collective intuition of millions of people who are interested in stocks anticipates future news with remarkable accuracy. But each of us, individually, remains in the dark.

When the current news is a surprise, the market of course reacts. If the reaction is in line with news that will be revealed several months hence, the reaction continues. But if the reaction is not in line with future news, the reaction doesn't last, and the market resumes the trend in effect before the surprise.

Many of us continue to believe that we can perceive underlying values on the basis of current news. But we're not all that good at record-keeping. We remember the good trades we made, but not the bad ones.

It's impossible to know consistently how a stock or a group of stocks will perform in the future. Our hindsight, however, is right on the nose. Which brings us to rebalancing:

Intermediate price trends don't continue indefinitely. The prices usually return to the mean. After an investment category has made a significant move to the upside, the chances are it will eventually slink back into the crowd. You're wise to sell a portion while it's ahead.

The same goes for the reverse. While an asset class is down a lot, it's a good idea to buy more.

Rebalancing means to sell a portion of categories that have been especially strong and buy more of the ones that have been weak. You're not predicting trends; you're reacting to trends that have already occurred, in anticipation of them reverting to the mean.

Rebalancing increases long-term returns without having to predict the future. Not a bad deal.