Rebalancing your portfolio to your long-term asset allocation targets can protect you from harmful portfolio drift.
Contrarian investors look at what the crowd is doing and act differently, provided that it makes sense. They sell ‘market darlings’ at high prices and use the cash to buy ‘fallen angels’ at low prices. By selling high what they previously bought low, contrarians usually make more money than others.
The trouble is, going against the conventional wisdom and acting as a contrarian investor requires having the courage of your convictions. All the same, there’s a way you can automatically follow a contrarian approach. You start by setting targets for your asset allocation. Then, as what’s known as ‘portfolio drift’ unbalances your portfolio, you rebalance.
Sell what’s costly, buy what’s cheap
Rebalancing would lead you to sell part of the asset class that did best and reinvest the proceeds in the asset class that did worst. You would continue to do this until you re-establish your desired asset allocation. More important, selling the relatively costly asset class and moving the proceeds as well as new money to the relatively cheap asset class means that you will have taken profits and will accumulate the cheap asset class at better prices.
As Mr. David Swensen, chief investment officer of Yale University’s investment office, puts it: “The portfolio should be rebalanced regularly to long-term targets. Rebalancing imposes a discipline that results in buying low, after a decline in an asset’s relative price, and selling high, after a rise in relative price.” (See more from Mr. Swensen below.) You can go even further.
Diversify as you rebalance
You can rebalance your portfolio among the five main economic sectors: finance, utilities, consumer, manufacturing and resources. You can also rebalance within a sector. Within utilities, for instance, you might buy stocks such as telco BCE Inc., electricity provider Emera Inc. and pipelines operator TC Energy (formerly TransCanada Corp.).
In fact, you can rebalance away from even just one stock. In September, 2000 we wrote: “It’s quite possible that Nortel Networks has come to account for more of your portfolio. In fact, it may weigh too heavily on your portfolio—just as it does in the market indices. In this case you might consider taking some profits from this manufacturing company.” Being a contrarian—selling Nortel while most were buying—paid off.
That is, rebalancing can let you profit from contrarian investing, eliminate portfolio drift and ensure that your asset allocation suits you.
Swensen’s swell strategy
Mr. Swensen likes rebalancing. In a seminar, he pointed out that many institutional investors make a mistake when they fail to rebalance their portfolios.
Mr. Swensen said that “Nearly every institutional investor, by failing to rebalance to long-term targets, engages in market timing and, accordingly, allows portfolio risk and return characteristics to drift with the market.
“An example comes from experiences during the October 1987 crash. In June, July and August, most institutional investors simply watched their US equity exposure increase as US equity prices were rising and bond prices were falling. Of course, by October 1987, equity allocations of institutions peaked, just in time to experience a traumatic, more than 20 per cent decline. After the crash, not only did institutional investors fail to buy equities, which were now much cheaper on a relative basis, but those investors exacerbated the problem by being net sellers of equities in November and December. By failing to rebalance to long-term targets, most institutional investors ended up buying high and selling low.”
This is an edited version of an article that was originally published for subscribers in the July 12, 2019, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
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