KEY POINTS:
Standard everyday financial advice would be a lot easier to follow if it didn't contradict itself so often.
One basic precept tells us, "Buy low and sell high". Then another warns, "Never try to time the markets". This may explain why people act so confused about the business
of money management.
Now, I'm as puzzled by life's paradoxes as the next guy. But I can suggest a way to wriggle out of this particular dilemma.
To buy low and sell high without market-timing, one need resort to nothing more than a simple old mechanical exercise known as portfolio rebalancing. It's so easy even a computer can do it.
There is nothing bold or macho about rebalancing. On a swashbuckling scale of 1 to 10, it ranks about a 0.5. It gets much higher marks, however, for such other virtues as discipline, prudence and consistency.
Every once in a while, say at the start of each new year, an investor adds up the current market value of the various asset classes among his holdings - stocks, bonds, money markets, and so forth. Some savings plans encompass just those three basic asset classes; others may include real estate, commodities, hedge funds and so forth.
Once the totals are summed, the investor matches them against the intended percentages in his asset allocation plan.
"You should review your portfolio at least annually, and rebalance it if your allocation of stocks and bonds has drifted from your target by more than five percentage points," says the Vanguard Group, which manages US$1.1 trillion in mutual funds.
If securities markets could be timed with any reliable expectation of success, there would be no need for rebalancing - or asset allocation, for that matter. You could just buy whatever was bottoming out at the moment, sell it at the next top, and continue rapidly along the Road to Riches.
Timing, alas, is very hard and fraught with risks. So instead, most careful investors adopt a diversified plan of allocating their assets. It might call for 50 per cent in stocks - say, for example, the Barclays S&P 500 Stock Fund - and 50 per cent in bonds - say, the Barclays Bond Index Fund.
Suppose you put $100,000 into each of those funds at the start of 2006. A year later, your bond fund stake had grown to $104,750 (the bond fund had a 2006 return of 4.75 per cent, according to Bloomberg), and your stock fund holding to $115,600 (the stock fund gained 15.6 per cent).
Not too bad. Notice, though, that your asset allocation is no longer 50-50. It's 52.5 per cent stocks, 47.5 per cent bonds. With a couple more years of this, the difference could get much bigger.
Rebalancing now can be accomplished by shifting $5425 from the stock fund to the bond fund. Problem: in any account subject to income taxes, that will involve capital gains taxes.
To avoid this snag, you can leave the existing amounts in the funds as they are, and do your rebalancing by rejigging the additional investments you plan to make this year into each fund. Current taxes aren't a problem in tax-deferred vehicles such as 401(k) retirement plans.
What does rebalancing accomplish? Well, it keeps the risk and reward of my investment plan where I intended it to be. It adds an element of discipline to help to keep the effects of my emotions in check.
And since rebalancing always steers money away from whatever asset class has lately performed best, it's an antidote to performance-chasing. "The number one thing that has hurt investors is the tendency to chase performance," says George Roche, former chairman of mutual-fund manager T. Rowe Price Group.
By definition, rebalancers sell high and buy low. That is not to claim that they sell at the absolute top and buy at the absolute bottom. I know this isn't so from recent personal experience, having rebalanced a while back out of a small stock fund, only to see that fund keep performing better than the other fund into which I moved the money.
If I had made that switch as a market-timing bet, I would now have to count it a mistake. But timing wasn't my intent. As a move to keep both risk and reward balanced in a consistent asset allocation plan, it still makes good sense - and I won't mess things up by trying to rectify my error with another wild guess at what the markets might do next.
* Chet Currier is a Bloomberg News columnist. The opinions expressed are his own.