Give your portfolio a New Year clean-up

To be a successful investor, you have to be disciplined. You need to decide on a strategy, allocate your money to your investments accordingly, and then stick with that through the ups and downs the markets will inevitably bring.

That doesn’t mean you have to be obsessively monitoring your portfolio on a daily basis. But you should review it regularly – and the New Year is the perfect time for many of us to do so. And one of the most vital jobs is ‘rebalancing’.

What is rebalancing?

None of us is able to predict the future. So a sensible approach to investment is to split your money between assets that behave in different ways depending on the underlying economic conditions. That way, you don’t have all your eggs in one basket, which should reduce the ups and downs of your portfolio and help you sleep better in the longer run.

So let’s say you put your money into five different types of assets, as shown in the chart below (this isn’t a recommendation, just an illustration).

Asset allocation chart

Over time, of course, the prices of shares, bonds, gold and other assets move around. Some rise in price, others drop. So after a while, your carefully thought-out portfolio is likely to look very different from your initial asset allocation. That’s why you need to rebalance – it simply involves buying or selling in order to get back to your target allocations.

So, in the example above, say gold had dropped in price and now accounts for just 10% of your portfolio, while your property holdings had risen in value to 20%. You would sell some property to get back to 15% and use the proceeds to buy gold and lift your holding back to 15%.

Why is this a good idea?

One of the biggest challenges for any investor is to control your emotions. Human beings have a tendency to act in herds. They chase the latest hot investment and sell out of the least popular stuff – in other words, we instinctively buy high and sell low, the exact opposite of what we should be doing.

If you think about this in terms of an overall portfolio, what happens is that the assets that do well (the ones that are getting more expensive) become an ever-bigger part of your portfolio, while those that do badly (the ones that are getting cheaper) become a smaller part.

Say you don’t rebalance and shares enjoy a bull market. At the time, you’ll probably think it’s great – your portfolio will probably rise in value too. But it may also become a lot riskier than you would like it to be.

If shares comprise 50% of your portfolio at the top of a bull market, then crash by 50% (as has been known to happen), your fund would lose a quarter of its value (50% of 50%). With regular rebalancing you would at least limit the damage. You’d have been continually taking profits as shares went up in price, and reinvesting in assets that had performed poorly.

In the late 1990s equity bull market, for example, taking profits on shares and reinvesting in gold would have worked out well. Buying cheap shares after big sell-offs in 2003 and 2008/2009 also proved profitable, at a time when most investors were scurrying for the perceived safety of cash and bonds.

So rebalancing allows you to buy low and sell high. That’s a practice that tends to make you money in the long run – it’s almost like putting your portfolio on contrarian auto-pilot.

Does it work?

I’ve found a couple of good studies that suggest it does – rebalancing delivers a better return, while taking less risk, than just letting your portfolio drift with the markets. David Swensen – the very successful US investor who runs Yale University’s endowment fund – is a big believer in rebalancing.

In his book Unconventional Success, he cites a study by investment company TIAA-CREF. The study took a portfolio that started at 49% shares and 51% bonds at the start of 1992. In one case it was rebalanced annually, in another it was left to its own devices. By 2002 the rebalanced portfolio had made more money.

US financial adviser Harry Browne has a similar example. He advocated 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.

More impressively, over the 39 years the rebalanced portfolio only lost money in four individual years, with a maximum annual loss of 4.9%. The other portfolio lost money in 11 years, and the biggest loss was 21.6%. The past may not repeat exactly, but which would you rather own?

How to rebalance – and how often

Rebalancing is best done within tax-efficient accounts such as individual savings accounts or self-invested personal pensions, as selling assets that have gone up a lot could trigger capital gains tax liabilities. As to how often to do it, the Yale fund managed by Swensen rebalances every day.

But that doesn’t make sense for the likes of you and me – it would take too much time, incur lots of trading costs, and be pretty pointless for the sums in an individual portfolio. Better to just pick a date and rebalance annually, or six-monthly. Or you could rebalance when an allocation is more than 5%-10% above or below where it should be.

You can also rebalance when you invest new money, by adding it to the worst performer in your portfolio. One thing to watch for is dividend reinvestment. It’s a great idea to reinvest dividends and compound your returns, but make sure you’re not automatically reinvesting into the most expensive part of your portfolio when you do so. It may be better to have dividends paid to cash, which you can invest on your chosen rebalancing date.