Bozo-Proof Your Portfolio

You've probably heard these two very respectable pieces of investment advice before, and probably from the same experts:

1. Stick with index funds. Most stock fund managers don't beat the market, especially after fees. So save the money and trouble and buy a cheap fund that passively tracks the S&P 500 or some other broad index.

2. Rebalance regularly. When the stock market goes up sharply, your stock portfolio will grow in value. That means you'll end up having more than your intended allocation in equities. The reverse is true if stocks drop sharply. Getting back to your target resets your risk and, as a bonus, means you automatically buy stocks when they get cheap and sell when they get expensive.

What if I told you that believing in both indexing and rebalancing is logically flawed? That's right: They are incompatible ideas.

The case for indexing is built in part on an idea called the Efficient Markets Hypothesis, which says that markets are extremely good at processing information and insights and then turning them into stocks prices. Maybe you think a stock is a great buy at today's price, but there's someone on the other side of the trade who has lots of good information who thinks its time to sell. With a world full of smart, informed investors facing off in the market, it's unlikely that you'll consistently be able to be on the right side of the trade.

And if you believe that about individual stocks, the same would seem to be true for markets as a whole. If stocks are rising, you are in effect second-guessing the market when you sell to rebalance.

Don't just take my word for it. Nobel-prize winning economists Bill Sharpe says so. And Jack Bogle, the founder of index-fund pioneer Vanguard, usually prefers staying the course. And contrary to the idea that rebalancing is inherently conservative, rebalancing involves plowing money into assets that are falling. That's great if the asset later bounces back. But it doesn't have to. (In the admittedly unrealistic situation where a stock drops straight down, the perverse result is that you'd rebalance until you went broke.)

I find these arguments against rebalancing pretty convincing, and that's why I don't do it often. (Money's Penelope Wang has an excellent take on all this here.)

But recently even Bogle has sounded flexible about the idea of stepping away from a hot market. One reason you might want to rebalance at least sometimes is that we don't really have an Efficient Market. We have an Efficient Market With Bozos.

The market isn't totally unpredictable, in other words. Some kinds of stocks, like cheap value stocks, seem to do better over long periods. High market prices as measured by gauges like the average price-earnings ratio do seem to predict low returns ahead. Low prices predict high returns. There are all kinds of possible reasons for these effects, but investment writer and adviser Bill Bernstein in a recent ETF.com interview attributes them to "bozos" in the market.

...dumb money piles into [the market], and that produces the inevitable popping of the bubble, and people say: “This is risky!” And they sell out, just at the wrong time.

Now, in practice, I'm uncomfortable (as I'm sure Bernstein is) with ever writing off the market as dumb -- doing so basically requires believing that everyone is stupid except oneself. You can make that argument at almost any time, depending on your level of self-esteem.

The reason the Efficient Market With Bozos theory is helpful isn't only about the other investors. It's about you—and me. We all have a bozo inside us.

A rebalancing rule, even when observed only sporadically, can protect you from getting swept up in market enthusiasm. When stocks are booming and you're feeling optimistic—or left out of the party because you weren't more aggressive—rebalancing pulls you in the other direction. Even if you don't actually do it, the thought that maybe you should rebalance and sell may be a brake on the urge to buy.

This may be more important to do when markets are rising. Although this may be bozo-ishly inconsistent and unempirical, I suspect that for most people rebalancing in serious bear markets is both too difficult and, in some cases, too dangerous. As 2008 showed, when markets are dropping hard, other risks—like the possibility that you'll lose your job—may be rising. And while the math might say that buying stocks when they are cheap will boost your returns, in falling markets you may also be at risk of tapping out your portfolio if you stay too aggressive.

In other words, it's better to defend yourself against the bozos out there than it is to try to take advantage of them.