How to buy low and sell high

Don’t put all your eggs in one basket. It’s an ancient piece of investment advice, and one that everyone should follow.

We’ve already looked at asset allocation and diversification in this series (which is what the City experts call ‘not putting all your eggs in one basket’).

But once you’ve put your investment portfolio together, how do you look after it and make sure it keeps doing what it’s supposed to be doing?

They key is to regularly ‘rebalance’ your portfolio.

What is rebalancing?

Let’s say that you’ve put your money into five different types of asset as shown in the pie chart below.

Typical portfolio asset allocation

By dividing your pot up like this, and putting different amounts into each asset, you hope that the portfolio will meet your financial goals.

The trouble is, the prices of shares, bonds and other assets tend to move around – sometimes very significantly. Some assets go up in price, while others go down. After a while, your investment fund could look quite different to what you started off with.

So rebalancing simply involves doing some buying and selling to get your money back to your target allocations. Say gold had gone up in price and now took up 20% of your portfolio, while property had fallen to 10%; you would sell some gold to get back to 15% and use the proceeds to buy property.

Why rebalancing matters

You can be lucky, but usually you have to be disciplined to be a good investor. Rebalancing helps you to stay disciplined.

One of the main problems with investing is that people become too emotional about it. Human beings have the tendency to chase the latest hot investment while selling out of stuff that has gone down in price – the exact opposite of what they should do.

If you think about this in terms of a portfolio, the assets that do well become a bigger part of the portfolio while those that do badly become a smaller part. Let’s say that you don’t rebalance your portfolio and shares experience a bull market and go up in value a lot. At the time, you’ll probably think it’s great, as your portfolio will probably go up in value too. But your portfolio would have become more risky.

If shares had become 50% of your portfolio at the top of a bull market and then crashed by 50% (which has been known to happen) your fund would have lost a quarter of its value (50% of 50%).

Now don’t get me wrong – it would still have lost 17.5% at a 35% allocation – but by regular rebalancing you could have limited the damage by continually selling shares as they went up in price and reinvesting your money into assets that had performed poorly. (In the late 1990’s equity bull market, selling shares and buying gold would have worked well, for example).

Essentially, rebalancing allows you to buy low and sell high – a practice that tends to make you money in the long run.

But does rebalancing work?

In theory then, rebalancing makes a lot of sense. But what about in practice? Well, I’ve found a couple of studies that suggest that it also works in ‘the real world’. You can get a better return with less risk than just letting your portfolio drift with the markets.

David Swensen – who runs Yale University’s endowment fund – is a big believer of rebalancing. In his book Unconventional Success, he cites a study by investment company TIAA-CREF which compared two investment approaches.

In one case, a portfolio with 49% shares and 51% bonds was rebalanced every year. Another portfolio started off from the same allocation but was left to wander with the markets. Between 1992 and 2002, the rebalanced portfolio made more money, despite the other fund having 70% of its money in shares in 2000.

US financial advisor Harry Browne advocated an investment strategy of equally dividing your money between shares, cash, bonds and gold. According to authors Craig Rowland and JM Lawson, between 1972 and 2011 a portfolio like this, rebalanced annually, delivered annual returns of 9.5% compared to 8.8% from the one that was left alone.

That might not seem much of a difference. But over 39 years, the rebalanced portfolio only lost money in four years with a biggest annual loss of 4.9%. The other portfolio lost money in 11 years with a biggest loss of 21.6% – which portfolio would you rather own?

How often should I rebalance?

The Yale fund managed by Swensen may rebalance every day. That doesn’t make sense for many private investors, as it would take too much time and incur lots of trading costs.

One option is to rebalance once a year. Alternatively, you could rebalance when an allocation is more than 5-10% above or below where it should be. Rebalancing is best done within tax free accounts such as Isas or Sipps as selling assets that have gone up a lot could trigger capital gains tax on large portfolios.

What about investing new money? The best option here is to invest it in cash or the worst-performing asset in your portfolio.

And how about dividend reinvestment? We like the idea of reinvesting dividends and compounding returns. But only if you are reinvesting into an asset that is not overpriced. This is easily done if you set up your investment account to automatically reinvest dividends. It might be better to pay them into your cash account instead and reinvest elsewhere.

Successful investing is never going to be easy, but rebalancing can certainly keep you moving in the right direction.

• This article is taken from our beginner’s guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here
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6 Responses

  1. 05/12/2012, mike Clark wrote

    Do you have an internet platform you can pass on to load assets on to for live valuations etc

  2. 06/12/2012, Monkey In York wrote

    Another good article by Phil Oakley.
    BUT what balance should we be looking for?
    I have 5% in Gold, 15% in Shares, and so forth, but what would be a good allocation?
    I note in the article that equal allocation was suggested

  3. 21/01/2013, David Cockburn wrote

    The advice given here to sell investments that do well and invest the money in those doing badly is often given.
    However it does mean that you end up with your money in a bunch of investments which are doing badly and may well continue to do badly. BP for example fell after the Gulf oil spill and has never regained its previous level. Pfizer fell pretty steadily for 10 years before recently starting to rise. And those are two examples of relatively well run companies. What if your investment had been in HMV; you would end up owning a lot of nothing.

  4. 22/01/2013, StephenL wrote

    I’ve never seen a research piece looking at the opposite approach of letting winning assets run and losers diminish in importance, tested acroos a number of different assets and discrete, long time periods. Whether those assets are individual stocks or whole asset classes like US Treasuries and gilts, the key is to ensure that a sizable chunk of the portfolio isn’t invested in something which produces a negative real return over the long run AND to keep adding to it all the way down. Gilts have been in a bull market since around 1980…but they were in a bear market from about 1950 until then.

  5. 25/01/2013, Cyril Ord wrote

    Here we go again, sell the good and buy the bad because it makes sense. What a load of nonsense. I’m pleased to be in the market this past month. It has certainly put a spring in my step!

  6. 23/01/2014, Taffy wrote

    A good article Thanks. But how do I know when an allocation is more than 5-10% above or below where it should be?

Commenting on this article closed

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