My simple message to investors is that if you manage your behaviour in such a way that will consistently take advantage of other investor’s mistakes of performance chasing or panicky capitulation, you can achieve comparatively superior, long term, real life returns.
Last week, I promised three simple methods of rebalancing an investment portfolio in order to take advantage of investment volatility.
Rebalancing is the process of returning a portfolio to an investor’s predetermined appropriate mix. This is necessary, because the movement of various investments and markets over time can cause the initial allocation to change.
Assets that have done well become a bigger piece of the pie, while laggards atrophy to a smaller proportion. By rebalancing a portfolio, you’re aiming to sell your hot investments before they turn cold and then use the proceeds to buy investments that are warming up.
The biggest benefit to rebalancing an investment portfolio is that it reduces risk.
By determining a proper asset allocation and regularly rebalancing, the investor—not the market—determines the level of risk in the portfolio. It’s always better to be the rancher than the cow!
The first way is to rebalance on a regular, periodic basis like annually. Research shows that rebalancing more than that is not useful!
You’ll work harder and longer, pay higher transaction costs and taxes and actually get paid less. It’s up to you, but I would suggest that you don’t do that!
Personally, I prefer to work less and get paid more. As a result, my favourite method of determining when to rebalance is not time based.
I prefer to set predetermined percentage targets around each asset class.
For example, suppose that I decided to rebalance once an asset class reaches a certain percentage level—such as 10% below or above my target allocation.
Thus if my asset mix goal is that a certain asset class makes up 50% of my portfolio, I would rebalance when that asset declines to 45% or grows beyond 55 %.
Suppose that I had a simple portfolio of 50% fixed income and 50% equities. If the markets were like they were last year, my fixed income portfolio may have grown to be 55% and the equity portion may have shrunk to 45%.
My parameters required that I trim the fixed income to 50%. In essence, I have just sold high and taken profits on my fixed income.
That 5% would then be rebalanced to buying more of the equities so that the asset class goes back to its original 50% allocation. I’ve just bought equities low!
My third method entails the use of the regular cash flows in and out of a portfolio to rebalance.
If you are still saving, you use your regularly contributed savings to buy more of the under-weighted assets and less of the over-weighted assets.
For those of you who are taking money from your investment portfolio, just do the mirror image.
Take more from the allocations that are currently up and less money from the allocations that are down.