How to ensure you buy low and sell high [Cambodian water festival: Most investors also lose money in crowds]

By Andrew Hallam

Special to The Globe and Mail

Published Sunday, Nov. 04 2012

Andrew Hallam is the index investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

Living in Southeast Asia gives me the chance to attend the Cambodian water festival. Locals and tourists pack the streets of the capital city Phnom Penh, laughing as they splatter each other with water to welcome in the new year – but the fun often comes at a cost. Pickpockets roam the crowd, lightening the wallets of the unsuspecting.

Shake your head at the tourists’ naiveté if you must. But most investors also lose money in crowds. And it costs them far more than it does Cambodian tourists.

The problem is our tendency to jump on stocks, bonds or real estate that other people also like. Even if we haven’t personally profited from Canadian bank stocks or Apple shares, we feel good about their future prospects, because their prices have shot up in recent years as the crowd has rushed in. We recoil, however, when somebody mentions the languishing Spanish or Italian stock markets. Other investors have fled those troubled regions, so why should we stick around?

It’s natural to think this way, but it’s a very expensive habit. Our desire to be part of the pack is a key reason why individual investors in 17 fund categories do far worse on average than the typical funds in those same categories, according to research firm Morningstar.

Investors fall behind because they can’t resist the temptation to jump out of areas with poor recent returns and hop into sectors that have already gone up. This habit ensures most of us sell low and buy high – just the opposite of what we should be doing – and typically shaves 2.5 per cent a year off our returns compared to how we would have fared by simply standing pat, according to the Morningstar study.

Avoiding this tendency can provide a big boost to your returns – and the way to do so is simple. Just develop a plan for allocating the assets in your portfolio across many different areas and types of assets, then rebalance your portfolio once a year to get back to your target allocation.

The great psychological challenge is the annual rebalancing. It means taking a deep breath, trimming back on your winning investments, and putting money into areas that have been falling – going where the crowd isn’t.

This pulls against the way most of us think. A good example of the problem: Readers constantly question why I have selected an international mix of index funds for my Strategy Lab portfolio. Don’t I know that Canadian markets have thumped the competition for much of the past decade?

I do. Nobody, though, can consistently predict which markets will do well in the future. Who would have looked at the lacklustre U.S. economy back in January and guessed that the S&P 500 would have soared to double-digit gains this year, handily outpacing the Toronto market?

The easiest way to make sure you’ll benefit from whatever happens is to set up a global portfolio of low-cost index funds, then rebalance once a year. Say your overall goal is to have a mix of 30 per cent Canadian stocks, 30 per cent international stocks and 40 per cent bonds in your portfolio. If your Canadian stock index fund has made big gains and now constitutes 45 per cent of your holdings, you would sell some and pour the proceeds into your international stock index fund and your bond index fund to get back to your 30-30-40 target.

Rebalancing is a way of acknowledging that different assets bloom at different times. For instance, bonds typically outperform stocks during the first stages of economic weakness as investors flee to their perceived safety. Stocks usually start outperforming bonds before a recession officially ends.

It’s next to impossible to predict when these shifts will take place, but a disciplined system of rebalancing ensures you’re not piling into a hot sector just as it cools. In a study titled Does Portfolio Rebalancing Help Investors Avoid Common Mistakes?, Steven Beach and Clarence Rose, professors of finance at Radford University, show that regular rebalancing produces better returns than chasing top performing sectors.

Rebalancing works best if you have a diversified portfolio that is spread out among several asset classes, ranging from Canadian stocks to global bonds. A lot of investors resist this notion – some, for instance, prefer an all-Canadian portfolio because they perceive it as safer than risky emerging-market stocks and the like.

I can understand how they feel, but those investors should remember that there are long periods – such as much of the 1990s – when Canada’s markets lagged behind the U.S. market and other global alternatives.

Think of it this way: A global portfolio ensures that if there’s a party going on for investors anywhere in the world, you’ll participate in it. Meanwhile, rebalancing ensures that you’re not having your pockets picked by blindly following the crowd. Both strategies make sense, whether you’re in Cambodia or Canada.

See Andrew Hallam's model portfolio here.