What's the difference between rebalancing a portfolio and timing the market?

The traditional definition of market timing is a trading strategy that attempts to beat market returns by predicting its movements and buying and selling accordingly. Based on that strict definition, rebalancing isn't market timing.

Rebalancing could be considered a form of market timing if the manager is making investment choices (trading). If it's just a matter of maintaining a structural allocation ratio (reducing imbalances) and no predictive component then again, no.

Having taken care of my investing for decades as well as retiring young, 3-4 years ago I interviewed fiduciaries who offered managed money with a fee of 1 to 1-1/2 percent. I had no problem with that if they could demonstrate outperformance, which some did, but most telling for me was how well they outperformed in down markets (lost less). None of the equity portfolios did much better than the market and that was a non starter for me. So I continue to DIY with hedging so that events like 2008 or this March's collapse don't chew up my nest egg.

AFAIC, for a person with 40 years until retirement, 1% a year compounded is a lot of growth to give up without outperformance.

As an aside, discount brokers like Ameritrade, Schwab, etc. offer managed money at reduced rates (well under 1%). The lower the fee the less frequent the rebalancing. I looked at some of these as well with the idea of opening one with the minimum of $5 to $10k and then duplicating their investments on my own, avoiding the management fee. But alas, their performance was even worse than that of the big boys (the aforementioned fiduciaries).

Rebalancing a portfolio makes no sense if you really think about it. You are selling off your winners to buy more of your losers.

Take Tesla as an example. In mid-Feb it made a high of $180 then dropped to $100 in early March. Someone rebalancing their portfolio might think that Tesla is now selling at a discount so might sell off another stock that is considered overpriced to buy Tesla shares and re-balance their portfolio. But Tesla keeps dropping for another 2 weeks to a low of $85.50 by mid-March. The strategy might be if the price doubles they will sell some off to rebalance the portfolio and if it drops further they will buy more. The price does start going back up and reaches $200 in mid-June. So now this person will sell-off their Tesla share because they are considered overpriced and buy something else dropping in price and considered cheap.

However, by selling Tesla at $200 they have missed the price rising further to a high of $442.70 in late August.

So a better and very simple strategy after doing fundamental analysis and thinking Tesla would be a good share to buy is to buy only after the price has risen 20% above its low and only sell once the price drops below 20% below its high.

So in this case the low was $85.50, so 20% above this is $102.60 in early April. The shares reached a high of $442.70 in late August, so 20% below this is $354. The price has recently dropped to a low of $368.60 so you would still be holding onto it. You can also place automatic stop-buy and stop-loss orders in the market so that you don't miss an opportunity to get in and one to move out if the price starts moving quickly. If the price continues to fall next week and goes lower than $354 you will automatically get out and make over $150 per share more than the rebalancing strategy, but if it reverses and keeps going up even further you will make even more. You will also only buy so-called cheap shares once they start moving up, avoiding buying into a collapsing share price. So you only buy into and sell out of the market when the market tells you to. This way your emotions don't get in the way of your trading decisions.

If the advisor is choosing to "rebalance" in response to market events or predictions like "if investments in US markets improve" I wouldn't call that rebalancing, I'd call it market timing.

Rebalancing typically is done according to a predefined plan and schedule. If you set a target asset allocation and decide that once a year around December you'll rebalance to reach that allocation, there's not really any market-timing going on because you aren't choosing when or how to rebalance based on the market. But if you're doing all kinds of trades when things go up or down, that's not really rebalancing.

It's true there can be a gray area because rebalancing is inherently tied to market performance in the sense that you will be reducing your holdings in whatever did well and increasing them in what didn't do well. So if you say "I'm going to rebalance to my target allocation . . . every day" then that might be indistinguishable from market timing. But still it's relevant whether those decisions are made on an ad-hoc basis or according to a preset plan.

In the end it's always possible to fudge the definitions to consider things as rebalancing if you're willing to fool yourself. Someone trying to lose weight might set a goal to walk a certain number of steps each day, but if they decide to get those steps in by walking to the donut shop they're probably not going to accomplish what they hoped by setting the step goal. Similarly, you can buy and sell all day and tell yourself it's "rebalancing" according to an illusory set of constantly changing requirements, but it won't have the same effect as real, disciplined rebalancing. I would be suspicious of an advisor who engaged in frequent trading but described it as rebalancing.

Before talking about 'rebalancing', it is probably best to try and define 'balancing' in the first place.

In short, there are different broad categories of assets you can invest in. The most common classifications would be 'equities' [the stock market], and 'debt' [bond market, government GIC's, t-bills - anything that earns interest]. Other categories could exist, most notably 'real estate', but for simplicity we will refer to debt and equity.

Debt typically has lower risk than equity - this is because a debtholder has a legal right to even, pre-determined payments, and must be paid back in full, if possible, at the point of bankruptcy. Because it is lower risk, it also has a lower rate of return.

Equity typically has higher risk than debt - this is because when you own shares, you only have a right to dividends that the company choose to pay, and at the time of bankruptcy, you would only get anything back if all other debtholders etc. have been paid out [very unlikely]. The tradeoff is that only equity holders truly reap the reward of profits from the company, and if the value of a company's future earnings doubles, then the value of its shares would theoretically also double.

One common piece of advice is to invest in a balance of debt and equity. How much of each you hold should depend on your risk tolerance, and specific circumstances like the time until you need the cash. [ie: if you want to buy a house in 5 years, don't invest in equities, because the market might dip when you need a down payment. Or, if you are going to retire in 10 years, consider reducing your equities and increasing your debt holdings so that you can more safely retire].

The balance that is right for you would depend on many things - but let's assume that you talk with a qualified advisor who is acting in your best interest, and they suggest you hold 30% debts and 70% equities. For simplicity, let's assume you have 50k in money to invest, so you would have 15k in lower-risk interest-bearing investments, and 35k in equities. After a year, you look at your portfolio - perhaps your debt holdings are worth still 15k, but your equity holdings are now worth 40k, because some shares you held increase in value. Rebalancing your portfolio would mean you would sell about 1k of your equities and buy about 1k of interest bearing investments, so that you maintain a 30%-70% split

In a way, rebalancing is actually avoiding 'timing the market', because it requires you to set, in advance, a series of rules that adjust your investment mix, instead of saying at some point 'I think the stock market is undervalued at the moment - I'll liquidate my bonds and keep buying stocks instead'.

Whether it makes sense or not is not an objective fact, but it is common advice that exists to make sure that you don't look at your portfolio in 10 years and realize that 95% of your investments are high-risk equities.