When it comes to investing, the one saying that most investors have heard countless times is to buy low and sell high. In other words, buy stocks when they are selling at the bottom of the market and sell them when they become overpriced. In theory, this is great advice. In practice, it is very hard for professionals to do and almost impossible for individual investors to do.
Many investors try to base their approach to buying low and selling high to where the economy is in the business cycle. When the economy is in a recession, stocks tend to be priced low. As the economy improves, the indexes that track the prices of stocks go up in value. They tend to continue to increase while the economy expands. This continues to occur until the economy falls into another recession. A recession is generally based on two consecutive periods of negative GDP growth. This business cycle historically runs its course about every decade.
The stock market has been making steady gains since March of 2009. Many people have grown wealthy as the result of those gains. That period of recovery and expansion has been going on now for over 8 years.
Many economists, professional investors, and members of the financial media are calling for a market correction based on where we are in the business cycle. Unfortunately, based on how the economy works, they are correct. Odds are, it will happen. The problem is that nobody knows for sure when it will happen. It could occur tomorrow or it might not occur until many years from now.
How can an investor buy low and sell high? To do so, an investor must buy investments that are priced low in relation to what the business is truly worth. Not only is this hard for individual investors to do on a quantitative level, it is hard to do on a psychological level. This requires investors to buy when the media is screaming to sell their stocks, people are losing their jobs, businesses are filing Chapter-11, and there is little hope on the horizon.
The best approach an individual investor should take is to not make investment decisions based on the current state of the business cycle. An investment plan should be created for all economic conditions. An asset allocation should be selected based on age and risk tolerance. When most investors try to buy low and sell high, they end up doing the opposite.
If it is that difficult to buy low and sell high, what should an investor do? A good starting point is to not try to time the market. Ignore the noise coming from the financial media. If you want to read about investing, go to my Resources page and select a book, blog, or forum that is recommended there.
As for buying low & selling high, there is a way for individual investors to do this. It is quite simple. It is called rebalancing.
Rebalancing is realigning the asset classes of a portfolio. Over time, a portfolio asset allocation will change because asset classes will perform differently. Small cap stocks might perform well, while international stocks might have negative returns. That will change the asset allocation of a portfolio. Rebalancing is performed by buying or selling asset classes periodically based on the performance of those asset classes within a portfolio.
For example, let’s assume that an investor has a portfolio that is made up of 3 mutual funds. The portfolio has 40% of its holdings in a bond fund, 20% in a total international stock fund, and 40% in a total U.S. stock fund. One year later, the investor reviews their asset allocation. Based on market performance the bond fund is still at 40% of the portfolio, but the international fund has dropped to 15%, while the U.S. stock fund grew to 45% of the portfolio.
To return this portfolio back to its desired asset allocation, the investor must rebalance the portfolio. They must sell off 5% of the U.S. stock fund and exchange or buy 5% in the international fund. That is simply selling the U.S. stock fund high and buying the international fund low.
How often should rebalancing occur? Most experts suggest at least once per year. I review my portfolio twice per year and rebalance at that point if it is needed. Some investors do it quarterly.
When do you know it is time to rebalance? A very simple approach is to set up rebalancing bands. I follow a +/- of 5% rule. As in the previous example, if an asset class is off by 5%, I will make the needed exchanges to sell high and buy the lower priced asset class.
Even though this is more structured than trying to know when to make a trade based on the headlines in the media, it is still difficult. It is difficult because of psychology. It requires an investor to sell an asset class that is performing well and exchange it for an asset class that is performing poorly. It is hard for the brain stem to realize that the poor performing asset class of today will be a market leader in the future.
If an investor struggles with pulling the trigger to rebalance their holdings, there is a solution. Many investment companies have an automated rebalancing feature. Today, most 401K plans have an automated rebalancing feature. It is as simple as selecting the percentage bands and frequency. This allows investors to bypass the psychological barrier of selling off the asset call that is growing for the asset class with recent negative returns.
If you want your portfolio to have high returns while reducing risk, buy low and sell high. The simplest way for the individual investor to do this is to periodically rebalance their portfolio. Based on percentage bands an investor should exchange shares of the best performing asset class for those that are lagging in performance. If an investor is struggling to follow this process, set it up where it is performed manually.
Please remember to check with a financial professional before you ever buy an investment and to read my Disclaimer page.