October's Market Highs Got You Spooked?

By Richard Schmitt

NEW YORK ( TheStreet) -- This year investors seem to like what the stock market is offering. Through three quarters, the Standard & Poor's 500 index stands 14.6% higher than where it began 2012. With the broad U.S. stock market still hovering near multi-year highs, many giddy investors continue to pile into the market for more good times in this election-year rally.

Never mind the market support offered by some pretty serious government intervention in the form of more monetary easing and continued deficit spending. When that gig is up, those sticking it out in the market can only hope that good old American ingenuity and resourcefulness will prop up an otherwise limp economy hobbled by tepid GDP growth of less than 2%, continued high unemployment that recently just eked below 8%, and an impending fiscal cliff that promises higher individual taxes to pay off record debt of over $16 trillion.

Then in our interdependent world economy, there's Europe with its own sovereign debt problems and China with its stalled growth.

These short-term worries for stocks are enough to give a buy-and-hold investor pause. Furthermore, his angst increased as he witnessed his set-it-and-forget-it portfolio facing a couple of harrowing market drops followed by equally impressive turnarounds since 2000. Yet after all this, the current market highs have only managed to bring this same guy's broad stock portfolio back to the level it first reached over 12 years ago.

If only an investor had the foresight to sell when the market was up and to buy when the market was down, he could have ended up ahead of where he is now. That's where portfolio rebalancing comes into play.

Periodically just take some money off the table when one asset class outperforms another by selling off some of the outperforming asset class and investing the proceeds in the portfolio's underperforming asset class(es). This portfolio rejiggering is intended to get an investor back to his original or target asset allocation.

Rebalancing allows an investor to reap gains in an overweight asset class -- like stocks of late -- and plow the proceeds into underweight asset classes -- like bonds or cash -- which may be poised to perform better in the future. Essentially, this rebalancing results in selling stock high to capture gains and buying other lagging asset class(es) low to set up future gains.

However, the current ultra-low interest rate environment presents a little twist on which asset classes to involve in rebalancing. Since a bond's value varies inversely with its interest rate, any inevitable increase in bond interest rates will invariably decrease the value of bond holdings.

So in our current low-interest-rate environment, proceeds from stock sales placed in bonds may not hold much promise for appreciation. Therefore, a modified form of rebalancing would call for placing the proceeds of stock sales in cash, rather than bonds, so as to preserve value.

With limited prospects for generating any significant increase in value through interest, cash becomes more of a placeholder, ready to be used to buy stocks when natural market volatility eventually brings prices back down. Then the buy-low-and-sell high premise behind rebalancing becomes more about getting into and out of stocks at the right times to set up and capture gains from stock market volatility.

Because taxes and trading costs generally cut into any gains brought about by rebalancing, many individual investors shy away from periodic portfolio rebalancing more frequently than annually. Yet this type of rebalancing on an even more frequent basis -- even daily -- becomes quite effective in producing lasting gains in retirement accounts, where transfers between funds do not trigger immediate taxes or direct trading costs.

Such is the concept behind 401(k) daytrading which, if done the right way to satisfy funds' frequent trading restrictions, will garner lasting gains in retirement savings.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Richard Schmitt is an actuary, adjunct professor at Golden Gate University, and author of 401(k) Day Trading: The Art of Cashing in on a Shaky Market in Minutes a Day.