By Joe Ferreira
This Insight builds upon our earlier post “Diversification or Di-WORSE-ification", which I recommend you refresh on or read next.
“Buy low, sell high.” This is the core thesis of most investment strategies going all the way back to Thales of Miletus. For those who don’t know Thales, he was an ancient Greek mathematician who one winter decided to buy all the olive presses in his region – when prices were rock bottom since it wasn’t olive pressing season. When spring came and everyone needed to make olive oil, Thales was more than happy to sell his olive presses…for a huge profit.
Thales may have been the world’s first value investor (and he certainly didn’t believe in diversification!). Many would try to replicate this strategy over the next 2,500 years. Spoiler alert: the vast majority fail.
So how do you execute “buy low and sell high”? What secret method exists to help investors know when to buy and when to sell? The answer is discipline, and something called rebalancing.
As we discussed last time, performance of different asset classes varies over time. Some will do well and others not as well, and over time, the performance of each will vary considerably.
To start, you need a target for how aggressive you want your portfolio to be (we will discuss this in a future Insight). For the sake of ease, let’s assume your portfolio was 50% stocks and 50% bonds. Now say that stocks had a terrible year and were down 25% whereas bonds were up 5%. Your overall return for the year would have been -10%, with the small positive return from your bonds helping reduce your downside (score one for diversification!). Your portfolio now has about 60% in bonds and 40% in stocks as a result of the stocks doing so poorly.
What about next year? From a high-level simplistic view, you have two options: A) do nothing and stay the course or B) rebalance back to 50% stocks and 50% bonds.
Now let’s assume that stocks had a bounce back year and are up 25% while bonds earned 2%. If you did nothing (i.e. option A above), you would have earned an 11.6% return. How does that compare to option B?
If you had rebalanced your portfolio back to the original target by selling roughly 10% of your bonds and using that money to buy stocks, you would have made 13.5%! It may seem like a small amount of money, but over time that kind of outperformance will have an enormous impact on your portfolio.
Although this is a simplified example extending only 2 years, the concept is backed by a considerable amount of academic research.
So, are you telling me that I should blindly trade back to my target portfolio allocation without considering what the Wall Street Journal or CNBC says about how markets will perform next year? Yes, that’s exactly what we are saying! Follow in the footsteps of Thales - buy when things go down and sell when they go up. You’ll be happy you did.