Before the why, three things you can take it to the bank on successful investment management-
1- Diversification. That is, don’t make any big bets. You need to have your savings deployed in a wide variety of investments. You don’t want to have all your money in the bank or have it all in the stock market or all in gold. Don’t go for an either or thing. There are about 16 to 18 major investible asset classes and market sectors. Stocks, bonds, government securities, foreign securities, natural resources, commodities and emerging markets. Depending upon where you are in life and the goals you are investing for, you could or should have a little bit of everything in a globally diversified portfolio.
2- Investing for the long term. That is, don’t try to figure out what’s going to happen today, tomorrow, next month or the next year. Look at the next decade. Look at that goal of getting your kid into college say in 10 years or your own retirement in 30 years. These goals being years and oftentimes decades out mean you can afford to think long term. And the best part is that the capital markets are far more predictable as that timeframe is stretched, allowing you to design and build portfolios that cater to those goals.
3- Rebalancing. And this is perhaps the most important yet most frequently ignored aspect of investing. Say you own two investments, doesn’t matter what they are, you own two of them and your money is split 50/50 between the two. We know that different investments perform differently over time but let’s say that one of them does better than the other and now your 50/50 split is 60/40. Rebalancing fixes that. Rebalancing requires selling some of the 60 down to 50 and buying the 40 up to 50, restoring the portfolio model to the way you wanted it to be. If one of those portfolio components happens to be exposed to a stock type investment and the other to US Treasury bonds, you can expect over time for that stock portion to go to 60% first and then to 70% and to 80% and then to 90% and all of a sudden, you are not 50/50 but 90/10. And you are 65 years old and it’s 2008, just in time for the stock market to crash and now you are hurting and instead of retiring at 65, you are now looking to retire at 80. That’s why you rebalance to reduce the risk that you’ll have too much money in any one investment or any one type of investment where one bad thing can wreak havoc to your personal finances.
This all makes sense, right?
And some say this is akin to market timing but it’s not because the difference between the two is huge. Market timing is making a change in your portfolio because of what you think is going to happen. Rebalancing is adjusting your portfolio because of what has already happened. In other words, when you have a 60/40 portfolio and when you bring it back to 50/50, you are bringing down the allocation to an asset that did well. You don’t know which one is going to do well. You know one of them will but don’t know which one so you wait to find out and after one of them goes up to 60, that’s the one you sell down. That’s the opposite of market timing. We are not guessing and that is why we are never wrong. The financial plans we implement will never go wrong for a simple reason that we are never trying to be right. We are not making a prediction of what is going to happen. We wait to see what has happened and then we respond. We only rebalance when the results are in.
So when should you rebalance? There are two general approaches. One is by time. Do we do it every month, every quarter, every year? Rebalancing by time is the most common way because you just do it by the calendar. Many 401(k)s do that. Every quarter or every six months, they rebalance your account. It’s simple, it’s painless and it’s easy. But it’s not very efficient.
If you are rebalancing on say March 31st, you miss out on something that happened on Feb 19th. You miss opportunities because of momentary fluctuations in the market. Or it’s March 31st and it’s the end of the quarter but there is nothing going on. So rebalancing by time is inefficient and we don’t do it that way. We do it by a set dollar amount or by percent of what we need in each asset class and we then let those percentages float within narrow parameters. A rebalance is triggered when those parameters are exceeded. You never really know when a rebalance is needed and the only way to know that is by watching the parameters of a portfolio like a hawk. Or you automate that process and that’s how we do it. That means you might not need to rebalance more than a couple times a year or you might need to do a dozen rebalances in a given year depending upon what the markets are doing. And this is way more efficient because we rebalance not when we need to rebalance but when it is necessary to rebalance.
But you sell something that has made money means taxes are due on that profit. But then you have your investments spread across taxable, tax-deferred and tax-free accounts and that flexibility allows you to rebalance in a way that eliminates the need to split those profits with anyone, not even Uncle Sam.
And that explains it all.
Image credit – Sadat Shami, Flickr