Rebalancing For Optimum Outcomes
The management of wealth is a dynamic process that presents uncommon challenges and opportunities. Markets rise and fall and portfolios fluctuate. The important thing to develop in such an environment is a strategy that will enable you to stick to a process that works and not to deviate from that system. What is important is wealth preservation and wealth enhancement over a reasonable timeframe.
Investment success starts with a sound asset allocation. Your asset allocation must match your financial goals and your risk tolerance. The underlying theory of asset allocation is that each separate asset class has unique periods of out-performance over time relative to its peers and that those periods occur randomly. The task of predicting the next year’s winning asset class is virtually impossible to do systematically in advance. A process of rebalancing automatically to a predetermined spread of all asset classes is a far superior strategy. To consistently benefit from the periods of out-performance it is necessary to distribute your resources over a range of asset classes over a long investment horizon.
Using long-term historical data it is possible to construct portfolios that will yield the optimum expected rate of return for any given level of risk over the long run. This is predicated on rebalancing periodically back to the optimum asset allocation. This rebalancing ensures that your portfolio doesn’t progressively grow out of kilter as one particular asset class outperforms for a period before reverting back to the long-term mean by suffering a period of under-performance. It systematically forces you to sell assets that have risen in value and to reallocate to those that have depressed prices. You are selling high and buying low.
This concept makes sense but is difficult to do in the midst of a market where the crowd is doing the opposite thing. John Templeton put it succinctly in the forward to Roger Gibson’s book Asset Allocation, Balancing Financial Risk when he said: ‘Probably no investment fact is more difficult to learn than the fact that the price of shares is never low except when most people are selling and never high except when most are buying.’
This makes investing totally different from other professions. For example, if you go to 10 doctors all of whom agree on the proper medicine, then clearly you should take that medicine. But if you go to 10 security analysts all of whom agree that you should buy a particular share or type of asset then quite clearly you must do the opposite. The reason is that if 100 percent are buying and then even one changes his mind and begins selling, then already you will have passed the peak price. Common sense is not common; but common sense and careful logic show that it is impossible to produce superior investment performance if you buy the same assets at the same time as others are buying.
Regular, automatic rebalancing helps you to re-weight your portfolio without any emotional or subjective overlay. If the key to success is to be buying and selling against the crowd but it is notoriously difficult to do then determining an appropriate long-term allocation and rebalancing regularly back to that allocation is the most effective way to sell high and buy low.
It is remarkable, despite the logic of this approach, how many investors find it difficult to follow the system after agreeing to implement it. There is always a reason for not progressively selling out of an asset that has done well and a real aversion to adding to those parts of the portfolio that have been lagging. It is important to have investors sign off on an investment policy statement and to agree to the implementation process before they are in the circumstance where the emotional overlay begins to cause doubts.
Asset allocation is the single most important determinant of a portfolio’s success. Harry Markovitz was awarded the Nobel Prize for economics in 1990 for his work on the importance of the relationships between securities within a portfolio. Modern portfolio theory adds a third dimension that evaluates a security’s diversification effect on a portfolio. Despite this knowledge being available, far too many investors focus only on the two-dimensional process of the return and volatility (risk) of an individual investment. Sometimes the focus is only on the return aspect without any regard to risk at all.