Question: I often hear you talk about buying low and selling high selling when an equity has moved up a certain percentage and then buying something that has underperformed. That tells me that you would have sold out of Apple when it was rising and bought into BlackBerry when it was falling. Youd have lost on both ends! And when you talk about buying both large-cap and small-cap funds as part of diversification, isnt it true that those simply move together as part of the overall market?

Ric: Youre referring to rebalancing one of three key elements of the investment strategy my firm uses. But theres a flaw in your Apple-BlackBerry analogy. Allow me to explain.

The first element in our investment strategy is extensive diversification: Our clients typically own 18 asset classes and market sectors from around the globe. The second element is that we maintain a long-term investment horizon. I dont care whats going on today, this week, this month, this year. Our clients are saving for their kids college in 10 years, their own retirement in 20. Or theyre already retired and focusing

on their life expectancy of another 30 years. (Yes, even a 75-year-old needs a long-term investment horizon!)

The third element, as I said, is rebalancing. Your understanding of how we do that is correct. Lets say we have two assets, and we place half our money into each. One goes up, but the other doesnt go up as fast, and suddenly you realize that your portfolio is no longer split 50/50. Its now 60/40 and thus no longer fits our original design. How do we fix it? We sell some of the 60 and buy some of the 40, just as you described.

Well, if youre selling the winner, youre earning a profit. And when you buy the loser youre buying low, positioning yourself for future profits. That is the purpose of rebalancing.

Our primary goal here is to reduce risk not to try to improve profit, although thats usually a by-product.

If you keep buying winners, soon your portfolio is 70/30, 80/20 or 90/10 and thus no longer diversified. Most of your money will be in one investment. If you had allowed that to happen going into 2008, you can guess the result. Thats why rebalancing is so important.

But heres why the example you cited is flawed. Instead of talking about an exchange-traded fund that owns hundreds or thousands of stocks, you specifically mentioned Apple and BlackBerry. This means youre not dealing with the overall risks of the market; youre focusing solely on two securities. And youre not taking a long-term view; youre looking at their recent performance.

Buying shares of a stock thats falling in price merely because its falling is not rebalancing; its called dollaring down and is a very risky strategy. Wall Streeters also call it catching a falling knife, and we would never recommend that approach. If this seems like a nuance, then all I can say is that nuances make all the difference.

Also, your contention that all funds tend to move together is false. The NASDAQ, the Dow and the S&P 500 often move differently, and that is why a wise investor owns a variety of funds to provide exposure to large-cap, mid-cap and small-cap stocks as well as those from foreign countries. This explains why we have so many asset classes in our portfolios (often 18) not merely two.

For more on our notion of portfolio construction, diversification and rebalancing, read my books The Truth About Money and The Lies About Money. Rescue Your Money provides a shorter explanation.

Originally published in Inside Personal Finance August 2014