Let’s say you have Asset A, which is a basket of stocks that will do well if we have rising inflation; and Asset B, which is a basket of stocks that will do well if we have falling inflation. If an investor believes the probability of each outcome is 50/50 he may choose to put 50% of the portfolio in Asset A and 50% in Asset B.

Let’s say rising inflation causes the value of Asset A to double and Asset B to fall 50%. Now asset A is 75% of the portfolio and Asset B is 25% of the portfolio. In other words, without rebalancing Asset A is 3 times as large as Asset B.

The value investor should assess the probability of the outcomes before rebalancing the portfolio. Let’s say the investor again believes that there is a 50% chance of inflation rising and a 50% chance of inflation falling. In such a case the investor would need to rebalance by selling some of Asset A (which had doubled) and buying more of Asset B (which is priced 50% less than the original purchase).

When the fundamental or intrinsic value of an asset has not changed, rebalancing forces you to buy more assets that are bargains and own less of assets that are expensive. For the value investor, rebalancing is a superior risk management tool compared to selling a stock just because the price has fallen.

Buying and Selling a Stock

Mentally prepare yourself for buying and selling a stock like you would consumer items. The further an item is priced below its real value the more you would be apt to buy! Think of investing the same way. Value investors will lower asset allocations to investments that are expensive and increase asset allocations to assets that are priced below their real valuation.

If you have done your research and understand the valuation of the company, the price you paid for the stock should not have an affect on your buy or sell decision. It is the current value compared to the price today that matters.

Don’t let loss aversion bias torpedo your investment returns. Forget about what you paid when selling a stock. What you paid for an asset has no bearing on the future price. Ask yourself; would this asset be worth buying now at today’s price? If not, sell it now.

When analyzing my portfolio I look at each individual asset and ask myself; is the current price an excellent value, does it provide a margin of safety? If not, I will sell it. If it does, I maintain my position and consider buying more anytime the price drops.

Once you own an asset the price paid should not enter into your buying and selling decisions. When selling a stock, it’s the value and price today that matters!

This article was republished with permission from Arbor Investment Planner.