- 9th Jul 2014
Set rules to protect your investments #investmentprinciple7
Once you are up and running you need to think about how you are going to keep on top of your investments.
An asset management strategy gives you the best chance of long-term success without doing anything especially sophisticated. To increase your chances even further consider regular rebalancing – that’s the process of returning your portfolio back to the mix you originally selected to fit your approach to risk.
Don’t let emotions get in the way
If rebalancing is the best way of protecting the returns on your investment, the best way to weaken those returns is by making emotional decisions. Trying to be too clever, chasing momentum, and buying and selling at the wrong time are classic mistakes investors make when they let their emotions rule the decisions they make. Two of the worst traits that investors often display are over confidence or its complete opposite – indecision – both of which can lead to missed opportunities.
An asset management strategy is vital to ensure you avoid the emotions that can destroy any portfolio.
Buying low and selling high
Over time your different investment types will generate different levels of return, skewing the mix of your portfolio. Although rebalancing is a simple concept and a vitally important factor in achieving long-term returns, realising its benefits is a challenge for many investors. This is because it involves selling assets that have recently done well and buying assets that have recently done poorly in order to return to the original allocations.
It may, at first glance seem counter intuitive to be selling successful investments rather than holding onto them. To help you understand why it’s necessary, you need to accept that investments tend to ‘mean revert’. (This is simply a posh way of saying that periods of above average performance are followed by periods of below average performance rather than maintaining upward or downward trends indefinitely.)
What rebalancing is actually doing is providing a very disciplined asset management strategy of buying low and selling high.
Managing risk not return
Given that markets can often take time to revert back to their long-term averages there are no certainties that rebalancing will pay off over your chosen timeframe.
Consequently, rebalancing should really be viewed as trying to maintain the risk/reward profile of your portfolio over the time you are invested for and which you chose in the first place. You just have to ignore the fact that, over some time periods and with the benefit of hindsight, it may turn out that it could have been better not to rebalance at all.
The fundamental purpose of rebalancing lies in controlling risk, not enhancing return.
It’s all in the timing
Rebalancing is not entirely a ‘free lunch’ as, in order to rebalance, some transactional fees and expenses may be incurred. The key, then, is to maintain discipline as to when and why the portfolio will be rebalanced.
It is sensible to set a target for rebalancing, for example when your original investment mix has moved by 5/10/20% or more. How often you rebalance will be dictated by this target figure; too low and you will forever be making changes – too high and your portfolio will no longer reflect your initial intentions.
In addition, your risk capacity should be measured annually or when a significant life event occurs – loss of job, marriage, divorce, the birth of children or the death of a partner – to determine whether any structural change in asset allocation is required.
Ensuring that you have a disciplined way of rebalancing your portfolio back to your chosen asset management strategy gives you the best chance of long term success without doing anything especially sophisticated.
Past performance is not an indication of future returns. The value of investments and any income from them is not guaranteed and can go down as well as up. If you have any questions about the suitability of an investment, you should seek financial advice.