Selling winners and buying losers
THERE are many great mistakes made whilst investing money, either by the individual, or institutional investor. None are more obvious than the loss of a successful discipline.
The pilot, who decides on that one day to ‘just have a go' rather than apply all normal processes, will sell more drinks on board than he will have future bookings.
Irrational exuberance, which is led by “it's different this time” or simply investing in ‘something' for fear of losing out, are two ways investors break away from traditional obvious discipline and feel the pain later.
The gravitational pull into a ‘winner' or to stay in a ‘winner' despite the obvious signs, has ugly downsides, year after year for many investors.
We all know there is an optimum time to leave a party or pay the two day hangover price, but it doesn't stop us doing it again. That is perhaps why, when markets are rising, we overestimate our tolerance for risk and when they nosedive we become overly fearful.
It is the calm pilot who will do what is counter-intuitive in those cases, and take the gains from the current ‘winners', and spread a little into the current ‘losing' investments.
And so how do investors, or their advisers, do this automatically?
We want no client of ours to experience unnecessary losses on their pensions and investments (your portfolio), so applying tried and tested methods of rebalancing, take away the risk of staying in a party too long.
For example, study of equity returns in stock markets from 1926 to 2009 show average annual returns of 9.93 per cent with the best year of 54 per cent, the worst of - 43 per cent, and a loss in 25 of the 84 years.
Invariably the greater losses come after a large surge in markets and is called a ‘correction' after the event, but never called a mistake before the event.
Return is achieved by taking more risk, which is why equities perform best, and, whilst simplistic, returns are balanced in a yin-yang way with bonds, cash and property, for example, as they are often negatively correlated (ie they perform in opposite ways during certain market conditions).
There have been many studies on the best mix between the assets above to smooth out risk and maximise returns, but the author of ‘how markets collide' Mohamed El-Erian's portfolio was the only one to actually outperform equities over an excellent study done between 1973 and 2013.
His portfolio advocated 53 per cent in equities, 23 per cent in bonds and 13 per cent each in commodities and property.
And so a calm pilot will build you a portfolio that has the correct spread of these assets and allow it to grow. Two mistakes are made here by investors: Using a manager with poor asset allocation skills; using a manager, or adviser who does not rebalance or reassess the assets and who just leaves it to ferment.
As markets increase or fall, the above percentages change. Leaving the portfolio invested for long periods of rising markets might now mean an exposure to 57 per cent equities (because of the gain they made) and 19 per cent bonds (because of the losses they made).
Now we have a plane coming in to land where some of the heavy folk on board have moved to the left hand seats, causing considerable ‘trim' difficulties for the pilot. That's called inappropriate risk.
Rebalancing is now necessary so ‘queue the air hostess' to return back to the seats.
Rebalancing works by automatically returning your portfolio to the ‘seats' it started in, so as to maximise and bank gains achieved, and minimise the losses.
How often? Actually all studies show there is no optimum calendar point, ie monthly, bi-annually, or yearly. Furthermore, more regular changes cost more, through labour, potential tax and transaction charges.
This week's rotation of stocks is a clear example of using an obvious trigger, as we rotate away from those that have over-performed and are potentially overvalued (notably certain tech stocks) back into those that have underperformed and are expected to do the best out of the US tax cuts.
Selling winners and buying losers has rewarded investors for many years and if you do not have a strategy with your investment portfolio, now is a better time than any.
:: Peter McGahan is the owner of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. Have a question on investments or pensions? Call Darren McKeever on 028 6863 2692, email email@example.com or visit www.wwfp.net.