Think about this for a second: What’s the one mantra you’ve probably heard over and over about investing?

“Buy low, sell high.”

Easy to say, hard to do — like really hard to do. Professionals, academics, novices, and everyone in between have been trying for literally centuries to perfect the science of buying an investment at its lowest price and selling it at its highest.

If there were a repeatable, verifiable method of buying low and selling high that worked 100% of the time, everyone would be doing it. Everyone! … and it would change everything. But as you start to try to wrap your arms around ideas like who would be doing the buying when everyone else is ready to sell -knowing the price is at an all-time high – you’ll begin to realize why it’s not possible.

So, can you harness the idea of buying low and selling high in a practical and meaningful way?

In short, the answer is yes — if you frame the low and the high around this word: relative. This means buying more of the investments that are right for your portfolio that are priced low relative to other investments in your portfolio. It also means selling portions of the investments that are right for your portfolio that are high priced relative to other investments in your portfolio.

Rebalancing

You accomplish this by doing something called rebalancing your portfolio. Rebalancing, as the name implies, brings your portfolio back into balance as it relates to risk-adjusted return potential.

If you’ve spent the time creating a proper asset allocation — a topic for another Back to Basics post — for your investment portfolio, you’ll better understand the right amount of stocks, bonds, cash, and alternatives you should be holding in consideration of your appetite for risk and need for return. However, as the prices of the investments in your portfolio fluctuate over time, the dollar amount held in each category and the percentage of the total that each represents can begin to vary widely from the likely more appropriate starting point.

Depending on market conditions, this can, for example, result in having too much in stocks or bonds in your portfolio and consequently leave you taking on too much or too little risk overall. The way to correct this problem is to rebalance.

An example

Let’s say you intend to hold 50% in Investment A and 50% in Investment B in your $10,000 investment portfolio, which starts you out with $5,000 in each. After one year, Investment A increases in value by 20% and Investment B decreases in value by 5%. This would leave you with $6,000 in Investment A and $4,750 in Investment B in your now $10,750 investment portfolio.

While a 7.5% total return sure is nice for year one, let’s say, for a first scenario, that Investment A is down 15% in the following year and Investment B increases in value by 5% without any intervention. This would leave you with $5,100 in Investment A and $4,987.50 in Investment B at the conclusion of two years, leaving your total portfolio value at $10,087.50 for a 0.44% average annual return.

For a second scenario, let’s go back to the end of year one. In this second scenario, at the end of year one, you rebalanced your portfolio back to the starting 50/50 split. You’d sell $625 of Investment A — which is high relative to B — and buy $625 of Investment B — which is low relative to A — resetting you to $5,375 invested in each. Repeating the results of year two above, you’d have $4,568.75 in Investment A and $5,643.75 in Investment B at the end of the second year, leaving a total of $10,212.50 for a 1.06% average annual return.

No big, gaudy total portfolio return numbers in either scenario, but notice that the average annual return more than doubled in our example when rebalancing was involved. Keep in mind that, during the rebalancing scenario, we actually sold a portion of the investment that had a positive total return for the two years and bought more of the investment that had a negative total return over the same period. Even if it seems counterintuitive, this is a practical and meaningful example of buy low, sell high in action.

Our example uses something called static, aka passive, rebalancing: Basically returning to the starting point without consideration of much else. In a tax-deferred or tax-free account like a Traditional IRA or Roth IRA — without any changes to your life situation or risk tolerance — this may make sense. However, you can use strategic, aka active, rebalancing in consideration of not just the starting point but also tax implications in a taxable account, changes in risk appetite, or even macroeconomic circumstances.