Passive investing, or investing in a benchmark index and letting the money ride, is probably the most time-tested and most-prescribed investment strategy in the world.
However, the recent sell-off in the momentum stocks may have exposed a flaw in strategies that take passive investing too literally.
The current sell-off has been led by the high-growth, momentum stocks like the social media and biotechnology stocks. Some of these companies are down by more than 20%.
The tech-heavy Nasdaq is down 8% from its March 5 high, while the S&P 500 is down a more modest 3%.
It’s certainly worth noting that the Nasdaq and its momentum stocks had been smoking the S&P 500 since the bull market began in 2009.
Rebalancing And The Flaw In Passive Investing
A good, thoughtful investment strategy typically doesn’t just have a generic allocation to stocks.
For example, if your strategy is to have 75% of your assets in stocks, it’s probably not just 75% in the S&P 500. That 75% would be a bit more refined. You could set strategic targets like 25% growth stocks and 50% value stocks; or xx% in tech stocks, yy% in consumer staples, etc. Your targets could actually mirror the mix in the S&P 500 today.
Most importantly, you would periodically rebalance your portfolio so that it continues to fit your strategic targets.
Rebalancing is crucial for managing the risk profile of your portfolio. If you didn’t rebalance during the dotcom bubble, then you would have found yourself extremely overweight dotcom stocks even if that was never your intention.
More recently, if you didn’t rebalance, you would have been too exposed to the high-flying, momentum stocks.
“There’s an important lesson from the recent rout in momentum stocks,” noted Joseph Paul of AllianceBernstein. “Investors who have bought into an index have also been buying into dream stocks, often unintentionally.”
“As these stocks rose to excessive valuations, they automatically became a bigger part of the benchmark.”
On the way up, you can benefit from the rally in these momentum stocks. But by rebalancing, you book some profits and limit your exposure to these high-flyers.
“In the aftermath of the correction, we think investors should reconsider the merits of buying the entire market without any scrutiny,” said Paul.