These are happy days for stock market investors.
The S&P 500 and the Dow Jones Industrial Average continue to set all-time highs. Volatility is staying low by historical standards.
From 2009 to 2013 the average annual return on the S&P 500 has been 18.4%, and all but one year (2011) enjoyed double-digit growth.
Beware The Emotional Pendulum
As reliably as day follows night, the mood among investors is shifting from the unabashed fear that ran rampant in 2008 to the other end of the emotional pendulum: greed.
Fear and greed are investors’ enemies.
Smart investing for the long-run requires sticking to a strategy meant to work in all market environments. It requires never giving in to the temptation of believing that “this time is different.”
This bull market, like all others before it, will end one day. Maybe tomorrow, or maybe further down the road. You need to be ready when that day comes. We’re here to show you how to prepare.
“Buy Low, Sell High” Put Into Practice
Those four words – buy low, sell high – sum up the entirety of long-term investing success. But how do you actually put this devilishly simple phrase into practice?
Nobody has a crystal ball with which to predict the future, so you’re only going to know in hindsight where any asset’s peaks and troughs occur. Even the professionals get it wrong more often than they get it right.
There’s another way to buy low and sell high – and you don’t need to be a Wall Street wizard to make use of it. We’re not talking about stock picking, or market timing.
We’re talking about diversification: slicing your portfolio into different and distinct asset classes, weighting each class according to your goals and risk tolerance, and staying disciplined through good markets and bad.
Sell Winners, Buy Losers
The crucial element is rebalancing. Here’s how it works.
Every year, some assets in your portfolio are going to do better than others. At the end of the year, the asset classes that outperformed fwill have a higher weighting than they did at the beginning. In other words, they’ll occupy a bigger “slice” of your portfolio.
Conversely, the dogs of the year will make up less of your total portfolio than they did at the beginning of the year.
Here’s a simple example. Let’s say you have a $10,000 portfolio with a starting asset allocation of 60% equities and 40% bonds. Over the course of the year, the stock market gains 20%, while the bond market returns 5%.
By December 31, your equities will have grown to account for 63.2% of the total portfolio, while your bonds will only make up 36.8%.To get your allocation weights back to the target 60/40, you will need to sell some of those high-performing equities and buy some more of the underperforming bonds.
This is where discipline battles with our fear and greed impulses. You probably don’t want to sell assets on a hot growth streak. But that’s what “buy low / sell high” is all about. It’s a contrarian approach. And it will more likely deliver you higher, more consistent returns than you would earn without a diversification & rebalancing approach.
The Tyranny of Drawdowns
Consider this:
From 1995 to 2013, the average annual price return for the S&P 500 was 11.6%. The average annual return for the Barclays US Aggregate Bond index was 6.3%.
Knowing this, you might argue that rebalancing would have been counterproductive for this period. Wouldn’t you have been better off leaving your portfolio alone and letting the stronger asset class work its magic?
The answer is no, you would not.
If you had invested $10,000 in a hypothetical portfolio of 60% stocks and 40% bonds at the beginning of 1995 and never rebalanced, that $10,000 would be worth $47,136 by the end of 2013 (based on the S&P 500’s annual price returns and making no deductions for fees and expenses).
However, that same $10,000 would have grown to $49,972 with an annual rebalancing back to the target 60/40 allocation weights.
How is this possible?
During this 18-year period there were two sharp drawdown environments, in 2000-02 and 2008-09. From the beginning of 2000 to the end of 2008, the annually-rebalanced portfolio would have grown by a cumulative 9.3%. During that same time the un-rebalanced portfolio would have lost 6.0%.
Drawdowns inflict real damage and impede the rate at which the portfolio can recover. Diversification and rebalancing help minimize the damage caused by drawdowns.
Getting Started
How should you diversify?
You can get started by using a resource like Jemstep, which gives you unbiased, expert advice that’s custom-tailored to your financial goals and risk tolerance. Jemstep helps you build a portfolio, make investment selections, and sends you rebalancing reminders.
Nobody knows when the next bear market will occur. A disciplined diversification and rebalancing strategy will afford you greater peace of mind.
Want investment advice that’s expert and unbiased? Visit Jemstep.