Some people visit the barber or hairstylist for a trim, or to just take “a little off the top” (or for a colouring to prevent those gray roots from spreading). They don’t want to change their whole look, but just stay well groomed.
It’s the same for investment portfolios. Maybe you own some stocks or funds you’re quite happy with and don’t want to make big changes. But keeping your portfolio looking good can improve its long-term appearance – and performance.
For instance, let’s say you have a blend of stocks and bonds (or stock and bond funds) in your portfolio. You own the bonds for some steady income or for some protection when the stock market falls. The stocks may be there so you can earn some dividends and to help your account grow over time.
Maybe you even started with the mix being 60 percent equities and 40 percent bonds – a classic balanced portfolio. But before you know it, the portfolio can get “unbalanced” and take your long-term plan off track.
When stocks are putting up huge gains – like the S&P 500 in 2013 or the Shanghai Composite in 2014 – and they are suddenly 70 percent of your portfolio instead of 60 percent, it’s time to rebalance. A good strategy is to trim some positions and add to others when the mix gets off track. So, you would sell some of the stocks that have gone up in value and buy more bonds to get the mix back to 60/40.
Or, if the stock market has had a terrible year – like 2008-2009, for instance – your bonds may have held up better and are now worth 50 percent of your account. That would also be a good time to rebalance by selling some bonds and buying some now lower-priced stocks.
By rebalancing to your target asset mix – in this example 60 percent stocks, 40 percent bonds – you accomplish two things. One is you buy low (by buying stocks or bonds that have fallen in value). And two, you sell high (by selling some stocks or bonds that are worth more than what you paid for them). Of course, buying low and selling high is the whole point of investing.
So, if stocks had a good year, take a little off the top and sell some at the higher price. Use the proceeds to buy more bonds at what might be a lower price, or just keep it as cash. You don’t have to remake your entire portfolio. Just sell enough to rebalance to your ideal asset mix – whether that’s 60 percent stocks, 40 percent bonds, or any other combination of stocks, bonds and other investments.
If bonds do better than stocks, trim your bond holdings and buy more stocks at a now-lower price. It’s not a difficult concept. And rebalancing on at least an annual basis gives you the discipline to buy low and sell high. And it keeps your portfolio well-groomed.
If you want to be more aggressive, market pullbacks – when stock prices fall relatively quickly and sharply – are a good time to rebalance as well. This would allow you to buy what might be great investments when they are “on sale.”
Beyond rebalancing, there are other strategies for slightly more active investors, like the 5 percent trim rule.
Let’s say you like investing in stocks and the market is rallying. You don’t want to cash out completely and miss out on more gains. But you don’t want to get exposed to too much risk either. That’s when your portfolio needs a trim.
Consider the 54 percent rally in China’s Shanghai Composite index in 2014 that continued into 2015. Had investors sold 5 percent of their portfolio per month starting at the beginning of 2015, they would have reduced their portfolio’s exposure to shares by roughly 25 percent by June. By then, the Shanghai index had rallied another 60 percent, in what was an unsustainable climb.
Throughout that entire market rally, investors who trimmed 5 percent a month would have locked in more and more profit. And they would have stayed invested and participated, although at a lower level exposure, as the market went even higher.
Even though the market peaked in June, if investors kept selling 5 percent a month during July, August and September, they would still have been making money, even though prices were no longer at all-time highs.
The 5 percent trim strategy even works when markets are falling. But in reverse – instead of selling 5 percent to lock in a gain, you buy 5 percent more at lower prices.
Of course, this would only work if for a high-quality investment that was only falling because everything else was in a downdraft. Buying a little bit more of a good investment at lower prices can really pay off once the price starts to recover. (Doubling down on a losing strategy is a fast way to go broke).
The 5 percent trim strategy works great because it allows investors to not only scale back risk and lock in profits, but it allows them to stay invested by not completely cashing out. It also gives investors the option to buy stocks at more appealing prices, all the while helping keep risk under control.
Don’t be afraid to act like your portfolio’s barber. Keep it well-groomed by rebalancing and don’t be afraid to trim a little off the top when prices are climbing. Your portfolio will thank you later.