By Allen Giese, CLU®, ChFC®, ChSNC®
After 34 years of advising clients about capturing global market returns, I’ve come to the firm conclusion that the investment policy for the masses is exactly backward from what is ingrained in us across other economic endeavors.
In the retail investment world, most investors buy whatever has gone up the most and sell the holdings in their portfolio that have not. Yet, with all the other things we buy that improve our daily lives, the reality is the opposite. When prices go down on the goods and services we seek, we get excited and purchase more. When prices rise high enough on those same goods and services, we start seeking out alternatives.
It’s just not so with investing. When prices drop on our investment holdings, the excitement we feel is more of the nervous variety. And instead of wanting to buy more, our base instinct tells us to flee—so we sell.
On the other end of the spectrum, when prices rise on our investments, the classic mistake we all know about but many do anyway is “chasing performance”—we buy more. It’s basic human nature, and for many in the investing public, it’s just too much of a “FOMO” (fear of missing out) not to participate.
And, of course, the financial media is there to compound the FOMO, whipping us up into a buying frenzy when we really can’t explain why a rational person would be making that buy. We become biased by recent history, and the more the price goes up, the more we want it. The irony is we know it’s not the best long-term investment strategy, yet we do it anyway. Over and over again.
In steps the concept of portfolio rebalancing—Step 1 of which is picking an investment allocation across multiple kinds of investment choices that you have a high degree of confidence will bring you to your goals. An allocation you know will get you where you want and need to be, but also one you can live with through good and bad markets.
Or, said another way, you put together a portfolio that you know you can live with across all kinds of markets (good and bad) and that you won’t have to change its basic design based on current market conditions.
To demonstrate how portfolio balancing works, let’s assume you have a simplified portfolio with just four types of investment choices: U.S. Large Companies, U.S. Small Companies, International Companies, and Global Fixed Income. You’ve decided to allocate equally across these four asset classes with a 25% stake in each.
On Day 1, your portfolio is perfectly balanced. But six months down the road, perhaps the International Companies have outperformed, and the U.S. Small Companies are struggling. Both are 5% off their target (the International Companies are now 30% of the portfolio, and the U.S. Small Companies are now 20%).
The rebalancing concept is simple: Sell off the 5% “over-weight” of the International Companies, and increase the U.S. Small Company position by 5%.
As I said, the strategy is simple—but very effective. First, it forces us to take human nature out of the equation. FOMO is not part of any of the reasoning. Second, it forces us to follow the most basic of all investment rules: Buy low and sell high!
In the example above, the International Companies are doing well. Their prices are rising. NOW is the time to sell enough to get back to the target weight and reposition those dollars to whatever is struggling. That struggling asset class will once again have its day in the sun, and for all you know, that day could be tomorrow.
Finally, rebalancing brings rationality into the portfolio. It is a much better long-term investment strategy. So, the next time you get notified by your custodian that we’ve made a trade in your account, that trade was a rebalancing move in most cases. We’re keeping your portfolio on what we believe to be a rational, non-speculative path toward reaching your goals. We’re doing what rational investors do.