It may sound counterintuitive, but it’s time to reduce your exposure to the top performers in your portfolio. Why? To help you practice what most investment experts preach: buy low and sell high.
Every investor over the age of 5 can grasp this concept, yet few truly put it into practice. Even with the best intentions, greed and fear can often cause investors to buy high and sell low.
Striving to rebalance your portfolio once each year may help avoid these costly emotional decisions. The end of the year is a good time to rebalance, whether you’ve properly diversified risks or you could use more diversification away from bond risk.
An effective annual rebalance should be simple:
- Reduce exposure from the strategies in your portfolio that have outperformed during the year (sell high)
- Increase the allocations to strategies that have underperformed (buy low)
This will rebalance the risk in your portfolio and potentially increase your performance.
Benefits of a better rebalance
To see the benefits, let’s look at the performance of two negatively correlated investments over a full investment cycle. Many investors would calculate the expected performance of these two assets based upon the simple average.
Initially, the simple average outperforms the rebalanced portfolio and the emotional cost, or performance envy, of diversification kicks in. Investors will instinctively want to intervene and weight their portfolio towards the outperforming asset vs. the underperforming asset. This often prevents them from capturing the long-term benefits of both assets.
However, buying low and selling high year after year to rebalance portfolio risk can provide massive outperformance over time. Yet the simple average ends up being just that: average.
The rebalanced portfolio ends up performing better and the investor experiences a smoother ride along the way. What’s not to like?
Flip your instincts for performance
By rebalancing portfolios annually in this way, you’ve put a failsafe in place to help protect investors from costly mistakes caused by greed and fear.
By reducing exposure to the portions of your portfolio that had a great year, fear works for you not against you because you’ve lowered your portfolio’s:
- Risk of loss; you’ve already captured real gains from that asset
- Concentration of risk, which may help you avoid large declines
Similarly, by increasing exposure to the portions of your portfolio that struggled, greed works for you instead of against you because you’ve increased your portfolio’s potential to deliver returns by:
- Buying quality strategies at lower cost
- Taking the opportunity to position your portfolio for next market cycle
With these measures in place, you’ve set up your newly rebalanced portfolio for potentially better performance in the new year.
That’s something worth celebrating!