Hint: It Relies on Rules and Procedures, Not Your Willpower or Gut Feelings

 

The savvy investor’s credo is to sell high and buy low. We’ve heard it so often, we shrug it off with an, “Of course, everyone knows that.” But when you think through what is involved, it’s actually rather counterintuitive. You’re being counseled to sell your winners and reinvest your money in losers, which not only fights logic but emotion as well.

There is, however, a logical, disciplined and emotionally neutral way to implement “Sell High, Buy Low.” It’s called “Portfolio Rebalancing” and the rules and procedures are established at the outset of the investment process.

The first step in the system is to establish a point of balance. Once you have determined your financial goals and time horizon, an investment portfolio is constructed with a strategic allocation of assets deemed capable of attaining those goals while maintaining an overall risk profile that allows you to sleep at night. Guidelines are set to define the kinds of assets that are aligned with your strategic objectives and investment preferences. Because asset allocation is the major determinant of risk and return in your portfolio, so you should change these weightings only if something in your personal financial situation has fundamentally changed.

Let’s say your strategy requires a portfolio weighting of 60% stocks and 40% bonds. A system to maintain that balance in your portfolio is necessary because asset allocation is a dynamic process. However carefully your portfolio has been constructed, it will drift away from that balanced set point because markets are always in flux, with returns fluctuating as industries, sectors, and entire asset classes – equities, bonds, commodities – pass in and out of favour. Over time, your portfolio will reflect the changing returns as different assets lead or lag each other. The percentage shares of outperforming asset classes will increase, while those of underperformers will shrink. As a result, without rebalancing, your portfolio will either be too aggressive to fit your risk profile, or too conservative to achieve your financial goals.

For example, if the equities in your portfolio go up 20%, the weightings in your 60/40 portfolio will have drifted to 72% stocks and 28% bonds. In this case, because the stock market has performed well, you might be happy with the short term effects on the value of your portfolio. However, you are now exposed to substantially more risk than you were originally prepared to take on and are more vulnerable to volatility in the markets. It’s important to get back on track with your strategic investment plan.

If your original investment was $1 million, rebalancing your now $1.12 million portfolio to its 60/40 weighting requires selling $48,000 in shares and reinvesting that $48,000 in bonds. Essentially, you will have sold the overperforming shares high, and bought the underperforming bonds low.

Theoretically, maintaining this balance could happen on an ongoing basis to keep up with changes in the markets. However, there are costs associated with trading and tax implications when you sell appreciated stocks. For this reason, you should determine upfront how often you are going to rebalance (i.e., annually) while allowing for an acceptable range in which assets can drift (i.e., 5% in either direction). There are strategies to mitigate the costs of rebalancing: for example, to avoid triggering capital gains taxes, you could rebalance by buying the appropriate assets with new money or selling within a tax-deferred account.

Your portfolio manager will also rebalance within the asset classes to maintain a strategically optimized and diversified exposure to market risk in exchange for expected returns: i.e., taking into consideration company size, relative value, expected profitability and global positioning.

The key takeaway here is that a regular strategy for rebalancing the portfolio has the effect of selling high and buying low, while keeping your portfolio aligned with your long term financial strategy.


Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada.  The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above.  The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd.  Rates are not guaranteed and are subject to change at any time without notice.