When markets tumble, this is your armour

Investing is a long-term business. We all know that. We're building our savings pots over the course of a couple of decades, not a couple of weeks. So we need to think and act like long-term investors, not fret over every little day-to-day movement in the markets.

The trouble is, that's easier said than done.

The fact is that financial markets move up and down a lot. And today's investors have more information on the markets being thrown at them than ever before. Thirty-odd years ago you would have had to actively seek out information on the stock or bond markets. These days you just need to flick on the telly, or open your laptop, and you're bombarded.

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It doesn't help that the financial media obsess over the daily (sometimes hourly) movements of the markets. And they love a bit of drama. A 2% fall in the FTSE 100 index might be described as a "plunge". A drop in the bond market is a "bloodbath".

It's not language that lends itself to sober analysis and calculated decision-making. Listening to this kind of stuff day in, day out can start to play on your mind. When markets fall, you start to worry that you might lose your hard-earned savings. So you panic and sell what's been going down, assuring yourself that you will buy back in when things settle down.

It works the other way too. You hear about a hot' sector that just keeps going up and up. You start to worry that you should have more invested in that area, and so you throw your carefully considered savings plan to the wind.

Stop. Calm down. Take a deep breath.

There's nothing wrong with thinking like this. We're all human. I've worked in the markets in one capacity or another all my life, and I know exactly what it's like. Experience teaches you not to listen to these feelings, but they never quite go away.

But the point is that getting stressed and selling out (or panic-buying) is the exact opposite of what a sensible long-term investor should do. You get the best investment returns by buying things when they are cheap, and selling them when they are expensive. Most people do the exact opposite buy on the way up and sell on the way down. That's a sure way to lose money.

So how do you prevent your own emotions from devastating your portfolio? This is where rebalancing comes in.

Overcoming your emotions: the magic of rebalancing

The whole point of rebalancing is to introduce an element of automation to your investment process. The more systematic your process the more it follows a simple, clear set of rules the less likely you are to be derailed by emotional decisions.

Rebalancing forces you to sell high, and to buy low. In doing so, it should not only based on historical performance boost your returns, but also reduce your risk.

Let's take a simple example to show how rebalancing works.

A simple example of rebalancing in action

Consider this simple example below with just two asset classes, shares and bonds. The returns of shares and bonds over three years (I've made these figures up) are shown in the table. You have split your money half and half between them.

A friend of yours has exactly the same investment plan. But he just sticks his money in at the start of the three years, then leaves it. You, on the other hand, know all about the magic of rebalancing.

So at the start of each year, you rebalance your portfolio. So for example, at the end of year 1, your portfolio will be more heavily weighted to shares (around 55.6%) than to bonds (on 44.4%), because shares have gone up by 25%, while bonds have stayed flat. So you sell some shares and buy some bonds, to get the allocation back to 50% each.

The table below demonstrates the benefits of doing this.

By rebalancing, you get an average annual return of 4.74%, compared with 4% for your friend who did nothing.

Rebalancing works in real life too

More often than not, this is the case in real life too.

Say you'd invested £100,000 equally between UK shares, UK government bonds, cash and gold at the start of 2003. You rebalance once a year. By the end of 2012, you'd have £246,000 an average 8.4% return a year. (I've used figures from the most recent Barclays Equity Gilts study to calculate this).

Left alone, the same portfolio would have returned an average of 6.6% a year. By the end of 2012, it would have been worth just £210,000 a difference of £36,000.

Here's another interesting thing. The rebalanced portfolio was less risky too. When we talk about risk in this sense, we mean how much the portfolio bounces about, and how big the swings are. You can think of it as being the "how easy is it to sleep at night with this portfolio" factor. The technical term for it is standard deviation'.

The rebalanced portfolio which delivered you a pot of £246,000, remember - has a standard deviation of 3.34%. For the one that was just left alone and ended up at £210,000 the standard deviation was 7.6%.

More return for less risk! It's the Holy Grail of finance.

This article is taken from Phil's Lifetime Wealth newsletter. If you want to read more, click here for details.

Lifetime Wealth is a regulated product issued by Fleet Street Publications Ltd. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Please seek independent financial advice if necessary. Fleet Street Publications Ltd. 0207 633 3600.

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose.