Rebalance Regularly to Minimize the Danger of the Next Bubble
Don't let a hot asset tempt you away from your investing strategy and into a bubble bath.
If there was one sure way for investors to lose a lot of money in the markets over the past ten years, it was this: Belatedly follow a herd that has poured money into the latest hot asset.
The biggest losers were those who loaded up on tech stocks in early 2000, who placed their chips on condos and real estate investment trusts (REITs) in 2006, or who piled into oil and farm commodities in early 2008. They blew the last breaths into asset bubbles that were about to burst.
Conversely, if there was one sure way to stay out of financial hell and make some decent returns in the past decade, it was this: Sell what the crowd was buying and place your bets on the assets they were shunning (see Profit by Betting Against the Crowd).
The big winners were those who bought bonds in the late 1990s, when bonds were considered stodgy investments; who bought stocks in the dark days of fall 2002 (near a Dow low of 7286) and early 2009 (near Dow 6547); or who bought REITs in 2009, after a two-year plunge.
In short, the path to investing success in the Lost Decade of the Aughts lay in bucking the crowd, being contrarian, buying low and selling high.
No, this did not require market-timing clairvoyance, which no one possesses. It did require using a technique that doesn't rely on market hunches, but puts your portfolio management on autopilot.
It's called strategic asset allocation with periodic rebalancing. The beauty of it is, you are forced to do what most investors find very difficult -- taking their gains and buying out-of-favor assets. Even when all asset classes are falling (or rising), you load up on the ones that fell relatively more (or rose relatively less).
Your most important decisions come at the start of the process, when you decide what kinds of financial assets you wish to own and in what percentages. (First, consult with a financial planner or study asset-allocation strategies.)
The asset mix you choose should reflect your age, wealth and tolerance for risk. If you're a young investor, you will tilt toward U.S. and foreign growth stocks, which are risky in the short run but offer the best long-term gains. If you're older or more risk-averse, you will want to allocate higher percentages to bonds and less-volatile, dividend-paying blue-chip stocks.
Because asset allocation is more about which broad classes of assets to own rather than which individual stocks and bonds, it works especially well with index mutual funds and exchange-traded funds.
A classically simple asset allocation might be 60% stocks and 40% bonds, but you could cut your pie into many more slices -- for example, 40% stocks, 20% bonds, 10% REITs, 10% gold, 10% other commodities and 10% cash.
The magic of asset allocation lies in the fact that, at any given time, some asset classes are having their day in the sun and others are in the doghouse. When you rebalance to maintain the predetermined percentages, you have to sell, say, your soaring REITs and commodities and reallocate the gains to unloved stocks. Try not to rebalance more often than once a year so that your profits will be taxed as long-term capital gains. Do not confuse this strategic asset allocation, which is formulaic, with tactical allocation, the market-timing technique used by many hedge-fund managers, who often trade rapidly among several asset classes.
Asset allocation with disciplined rebalancing would have reduced -- but not eliminated -- your pain from the burst bubbles of the past decade. And it will surely minimize your grief when the next bubbles -- in my opinion, U.S. Treasury bonds and gold -- eventually fizzle, too. While other investors run with the pack, pouring more and more money into these overpriced assets, you will be gradually reducing your exposure -- and sleeping better at night.
Columnist Knight Kiplinger is editor in chief of this magazine and of The Kiplinger Letter and Kiplinger.com.