Investment picks are rebalancing act

Do you have a personal investment policy? If so, you knew how to behave these past four months. If not, you voyaged from "should I sell?" to "too late to sell now" to "what stock market? I'm too busy playing Second Life".

When equities rise again, you'll claim that your strategy always has been to buy and hold.

Excuse me, but that's the dumb money. Lower prices for stocks are a chance to buy at, well, lower prices. They might drop even further. OK, that's another chance to buy. In the next up cycle, 2008 prices will look cheap.

The question is, how to execute a strategy like this, which requires you to ignore the protests that come from your gut. The answer is: Create an investment policy. When markets rise or dive, the policy tells you exactly what to do.

Investment policies come in two parts.

First, an asset allocation. You decide what percentage of your money you will keep in stocks and how much in bonds.

A simple example would be 60 per cent stocks, 40 per cent bonds. Within those broad investment categories, you create subsets - a certain percentage allocation to large and small domestic stocks, international stocks, emerging markets, Treasuries, high-yield bonds and so on.

The second part - the one most individuals ignore is rebalancing. That means keeping your allocations at the levels you originally chose. If stocks go up by enough to make them worth 65 per cent of your portfolio, you're supposed to sell that surplus five per cent and put the proceeds into bonds. If the value of bonds goes up, you sell the surplus and invest it in stocks.

Adding value

Years of research show that rebalancing adds value and reduces risk. You cash in some profits from the assets that went up and reinvest them in the assets that underperformed. When the market turns around, those underperforming assets will rise again. By rebalancing, you bought them cheap.

There's one big problem with individual investment policies. No one wants to sell stocks when they're going up. You let them become an ever larger portion of your portfolio. As a result, your so-called asset allocation plan is imaginary. You've put yourself into the hands of chance.

Take the recent stock market embarrassment.

According to the formula, you should have trimmed your US stock allocation in late 2006 or early 2007. But you probably didn't pull the trigger. You were into your fifth year of higher prices and nothing in the news implied hard times. So you sat tight. Stocks topped in July. At this writing, the Standard & Poor's 500 Index sells for less than it did in late 2006. Investors who failed to follow the formula gave up all of the intervening gains.

They also lost the money they'd have made by reinvesting in bonds. Stock investors hate bonds. They know that bonds only limp along. But guess what? Intermediate-term Treasuries returned a total of 10.3 per cent in 2007, according to Morningstar, compared with 5.8 per cent for the S&P 500. Over the past eight calendar years, Treasuries yielded 6.8 per cent compared with 1.7 per cent for the S&P 500. That's one of the best-kept secrets on Wall Street.

Investment policies work but only if you follow though. Rebalance when any of your allocations falls five per cent out of line. Do it automatically, without second-guessing the discipline. If you stop to ask whether stocks will fall (or rise) some more, your long-term plan is toast.

Mimic the market

"Policy" investors usually keep their money in mutual funds, not actively managed funds, where gains and losses depend on the manager as well as the market. They choose index funds or exchange-traded funds that mimic the market, to keep their asset classes clear. All of the research on asset allocation has been done using market indexes.

Rebalancing becomes difficult when you own individual stocks. In theory, you'd sell stocks that represent popular industries and therefore might be overpriced - energy, for example. But it may not be clear which industries those are. You might wind up selling a stock that's reasonably priced and keeping a high-flier that brims with risk. You also don't want to be moving money in and out of individual bonds.

No training wheels

Index mutual funds, by the way, aren't investments on training wheels, as Wall Street propaganda would have you think. Increasingly, institutions are using index funds or exchange-traded funds as their core investments, rebalancing as they go. The risk reduction they get from this approach frees them to make more speculative bets on hedge funds, commodities, currencies and individual country funds.

That's a good model for you to follow, too. Index and rebalance your serious money. Set aside five per cent of your investment pot for a "hobby" portfolio, where you play your hunches and try to prove that you're smarter than the global market that's bidding against you. Who knows? Maybe you are.

If you're rebalancing now, you'd be buying the S&P and selling bonds. Investment policies give you a strategy - just what you need, in times like these.