Q. Have you ever done any calculations into the optimal time to purchase index funds or ETFs based on broad market indicators? I’m essentially talking about buying during market dips and corrections, perhaps based on moving averages. — Joe S.

Canadian and international stocks are now in negative territory for 2011, and even US equities have fallen more than 5% since the beginning of May. If you’re an index investor with a global strategy, does it make sense to wait on the sidelines for opportunities like this? Can you enhance your returns by identifying the right time to buy?

Let’s call a spade a spade here: this is market timing. It is always possible to look in the rear-view mirror and identify what would have been the optimal time to buy into any asset class. But trying to spot buying opportunities ahead of time, based on moving averages or other technical indicators, is likely to be futile and costly.

Besides, the Couch Potato strategy already includes a technique for buying into asset classes when they’re “cheap.” It’s called rebalancing.

About once a year—or when your portfolio’s target allocations are out of whack by a certain amount—it makes sense to trim the best performers and use the proceeds to prop up the winners to get the portfolio back to its targets. (You can use my rebalancing spreadsheet to help with the math.) But rebalancing doesn’t have to involve selling anything. Another way to keep your portfolio balanced is to add new money to asset classes that have recently underperformed.

Say, for example, that your long-term strategy calls for equal amounts of Canadian, US and international stocks. Over the last 12 months, US stocks have dramatically outperformed the other two asset classes, so your portfolio would now be out of balance. If you have new money to add, you should use it to prop up the Canadian and international equity funds until all three are equal again.

Rebalancing is not market timing

It’s crucial to understand why you’re doing this. When you add new money to Canadian or international stocks today you are not making a bet that these asset classes will outperform the US over the next 12 months. You are not making a forecast of any kind. You are simply recognizing that all asset classes should eventually revert to the mean.

Remember, the long-term expected returns for Canadian, US and international developed markets are the same. From 1970 through 2010, their performance was within 70 basis points of each other. The reason you should hold all three in your portfolio is that they do not move up and down at the same time. By diversifying and rebalancing, you reduce your portfolio’s volatility and potentially increase your overall returns at the same time.

Trying to time the purchase of index funds or ETFs based on market indicators is tempting, but it’s incompatible with a passive investing strategy. You are likely to be better off by building a well diversified portfolio, adding new money whenever you have it, and rebalancing regularly to stay on track.

Got a question about index investing? Send it to [email protected] and it may be answered in a future installment of “Ask the Spud.” Answers are provided as information only and do not constitute investment advice.