"Conservative," "aggressive," "active," "passive," "strategic," "technical." These are all common words which mean different things to different people.

A couple of months ago when I started to write about rebalancing, I received a number of e-mails suggesting that the so-called "rebalancing premium" was the result of market timing. Timing will make a difference. Buying at a bottom or selling at a top certainly beats missing a bottom or a top. But in my view, rebalancing is not market timing. Whether you agree is largely dependent upon your definition of the term "market timing."

Market timing can be hard to define but is easier to identify if we take an extreme example of behavior most people would dub market timing. A strategy that attempts to outperform a market by moving 100% of a portfolio in or out of that market in anticipation of a near-term change in market direction would qualify as market timing.

The first element of this scenario to consider is the percentage of the portfolio going in or out of the market. The larger the percentage, the more likely the action is to be viewed as market timing. In a rebalancing scenario, the percentage of the portfolio subject to a transaction is relatively modest.

For example, consider a simple scenario consisting of a portfolio that targets a 50/50 split between A and B with $100,000 in each. A stays flat while B loses 40%. The total is $160,000 (A=$100,000 and B=$60,000). To rebalance, $20,000 is moved from A to B so each has $80,000. Even after waiting for a 40% drop or a 62.5/37.5 mix, rebalancing to the original target requires only 12 1/2% of the portfolio to move from A to B. Rebalancing at a point where B has declined 20% results in a $10,000 transaction or a move of less than 5.6% of the portfolio ($10,000/$180,000).

The second element of market timing is its short-term nature. Timers want in before a market rises and out before a fall. As volatile as markets can be, this can lead to frequent trading. This is probably the weakest sign of market timing because volatile markets also can trigger a series of rebalancing transactions in a short timeframe.

The third element -- intent -- is perhaps the strongest sign of market timing, but is not always evident just from viewing transactions. Market timers often take pride that they are taking advantage of the very volatility that can drive others nuts. I find this ironic because those that would describe themselves as strategic asset allocators or similar typically also take pride that they are taking advantage of market volatility through rebalancing.

Nonetheless, the difference between the intent of the market timer and rebalancing is significant enough to form a belief that they are two very different things. The intent of the market timer is to eliminate the risks of exposure to a market by being out of the market before a decline. The intent of rebalancing is merely to lower the risks by reducing, but not eliminating, the exposure to a market because the portfolio has more exposure to that market than desired. From time to time, market timing seeks zero risk from a market, while rebalancing typically would not reduce exposure to zero.

Of course, if we go back to our simple 50-50 portfolio, when we rebalance, that $20,000 drops its exposure to A to zero and is exposed 100% to B. In fact, total exposure of the portfolio to B was increased by 33%, implying a strong conviction that B will rebound. Some may get bogged down on this and say that while this is not market timing with the entire portfolio, it is timing with $20,000. I disagree. The motivation behind the transaction is not driven by anticipation of a rebound in B or a drop in A soon after the trades are executed.  

Further, taking the position that one is timing the market with the $20,000 because none of those funds are invested in A means that just about any transaction would be market timing. I doubt anyone would say that if Bill Gates sold a single share of Microsoft that he was engaging in market timing even though he was reducing his exposure to Microsoft by the value of that share. While an all-in or all-out transaction with the whole portfolio may smack of market timing, selling one share clearly does not, given the share's proportion to the entire portfolio. The sale implies a different intent.