Buy low and sell high. This is the fundamental rule of investing, yet it can be remarkably hard to put into practice in the real world of portfolio management. As investors, it seems we are hardwired to chase performance and allocate to sectors only after they’ve already seen their greatest moves.
The best way to continually buy low and sell high is to systematically rebalance. Of course, if you are young and your 401k account balance is relatively low, you effectively rebalance every pay period when you add additional funds. But if you’ve been investing for a while and your account balance is well into six or seven figures, those regular paycheck contributions make up an increasingly smaller piece of the pie. Rebalancing becomes increasingly important the larger your account balance becomes.
How does this work in practice? The asset classes at your disposal will vary from plan to plan, but most will offer, at a minimum, a selection of large-cap, small-cap and mid-cap funds. If you’re lucky, your plan might also offer REITs, MLPs, foreign stocks, dividend-focused funds or other, more exotic asset classes.
Build an asset allocation that, while heavy in high-quality large caps, also gives exposure to these other asset classes. Historically, foreign stocks, REITs, MLPs and small and mid-cap stocks have all offered competitive returns, but they don’t necessarily track each other in any given year. Once per year, sell the asset classes that have outperformed and reallocate to those that have lagged. In 2014, for most investors this would mean reducing your exposure to U.S. large caps and reallocating primarily to foreign stocks and REITs.
You’ll notice I conspicuously left bonds out of the discussion. There’s a reason for that. Bonds have lower expected returns than the other asset classes discussed, and this is particularly true given their low yields today. Consistently reallocating to bonds given current yields may reduce portfolio risk, but it will do so at the expense of also reducing expected returns. So, the rebalancing I’m talking about here should be understood as rebalancing among growth asset classes with comparable expected returns.