The magic of rebalancing

The magical benefits of rebalancing

Suppose one of your investments shoots 40% higher.

What are the chances of it doing so again soon?

Not impossible, of course! But also unlikely.

Too often investors experience exciting results, only to undo all the good work by giving back most or all of their paper profits.

As Benoit Mandelbrot said in The (Mis)Behaviour of Markets:

‘Take a profit’.

Rebalancing: a stylised example

For the sake of simplicity, let’s say you have $100,000 and decide to begin with a 50/50 allocation to stocks ($50,000) and cash ($50,000).

We wouldn’t recommend it, but suppose you make a dreadful mistake and decide to invest immediately before stocks crash 50%, dropping your portfolio down to $75,000.

To rebalance back to a 50/50 allocation you take $12,500 from your cash to buy more stocks, so that you have $37,500 in each pile.

And then the stock market bounces, rising by 100% back to where it started.

Although the stock market has taken a round trip to nowhere, you have a portfolio of $112,500 and a profit of $12,500, while the buy & hold investor still has $100,000 before accounting for dividends and inflation.

Of course, this is an unrealistic and stylised example – and when stock markets are cheap you may well want to be more than 50% invested – but this oversimplified example shows how rebalancing can help you both to manage exposure/risk and capitalise on great buying opportunities.

What a Turkey!

Let’s take a look at Turkey, a volatile emerging market that’s delivered handsome pickings for us in the past.

ETF returns range from a tremendous 126% in 2003 (dinner party bragging rights!) to a gut-wrenching 62% loss in 2008 (the sort of year where greedy investors undo all of their previous good work).

Rebalancing helps you to limit the destruction that years such as 2008 can do to your portfolio (in fact one of our timeless investment principles concerns macro valuations/mean reversion, ensuring that we’re not exposed to such expensive markets, though that’s not the point we’re making in this post).

Importantly, practising rebalancing also means you pocketed some of the handsome returns from the preceding years of 126%, 42%, 57%, and 75%.

It also means that you have cash available to invest after the crash, so you almost doubled your money again on the rebound in 2009, when the market surged 99% higher.

Source: Novel Investor

This example is not just hindsight bias and cherry-picking figures; it’s making an important point.

Because of the interplay between momentum and mean reversion, you must take profits off the table at the highs and put them back in at the lows, both to manage risk and to maximise returns through the cycle.

It’s always tempting to hold onto winning investments for longer, but this risks giving back all those hard-earned gains.

And always remember the detrimental impact of negative numbers on compound returns: a 25% gain is completely erased by a 20% loss.

So, take a profit!

Managing exposure

Professionals rebalance their portfolios to manage risk, and you can too, either on a percentage basis or on a time basis.

Rebalancing systematically on a calendar basis may be easier, as it’s often psychologically hard to sell winners due to the inevitable bragging rights attached.

You can rebalance your portfolio weekly, monthly, quarterly, or annually if you wish, and this simple practice can force you to buy low and sell high.

Remember the famous quote from Bernard Baruch:

‘I made my money by selling too soon’.

You can find out more about our coaching programs here.

Yes, you can buy low…and sell high

The bipolar moods of Mr. Market

‘Buy low, sell high’ is one of those sage pieces of advice that just sounds too simple, but it can be done.

Stock markets are mean reverting, so although they swing higher and lower through the cycles, over time markets tend to revert towards a long-term mean or average valuation.

Because stock markets are liquid they can be volatile, but this volatility can be both your friend and your opportunity.

Legendary value investor Ben Graham used the analogy of the bipolar Mr. Market.

Some days Mr. Market is depressed and offers you an irrationally low price; other days he is exuberant and offers you a foolishly high price.

You just need to be able to recognise the difference between the two states.

Your ability to buy low has two simple components.

Firstly, the patience to wait for great opportunities to come around, and secondly, acting when the time comes instead of confusing the noise (gloomy media and market commentary) with the investment signal (markets on sale).

Blood on the tracks

What happens when you buy markets when they’re cheap and when there’s ‘blood on the streets’?

The simple answer is massive outperformance:

Source: Meb Faber

Now look at these returns and tell us that buying low is risky!

Source: Meb Faber

There’s an old saying that an investment ‘well bought is half sold’, meaning that as long as you buy cheap the question of when to sell will eventually answer itself.

Note that to take maximum advantage of this strategy you need to be able to buy low and then sell later to lock in your strong gains.

When you back-test the figures it becomes clear that the blitzing outperformance often begins to fade after 12-24 months (this makes sense, since after a strong rebound returns should begin to revert back towards their long-run average).

Buying low in action

Let’s take the contemporary example of the Pakistan ETF, for the simple reason that this has been one of our most recent investments (note: this is a personal investment undertaken by us, not financial advice).

Pakistan’s stock market was savagely hammered from 2017 through to H1 2019 as interest rates suddenly steepled higher (after all, why invest in stocks when cash is paying double-digit returns?).

But remember what happens when you invest in markets that have experienced brutal downturns?

That’s right!

And this was our signal to get buying:

Source: Novel Investor

An interesting point of note is that over the past 15 years Pakistan – alongside Greece – has been one of the worst performing emerging markets.

But that’s precisely the point.

We wanted to invest because it’d become so unloved and cheap (with a healthy dividend yield of 9.5% to boot), and because all countries will have years when they deliver huge returns, both positive and negative:

Statistics over stories

Now at this point people tend to rear up at us with a barrage of emotion-laden counterpoints.

But interestingly they’re normally based upon preconceived notions and biases rather than logically being founded upon any factual evidence.

Don’t be fooled by the folksy bonhomie – great investors such as Warren Buffett beat the market by relying fastidiously on statistics over stories.

Don’t forget that so many of the popular investing mantras are consistently promoted by a self-interested finance industry:

‘The best time to invest is today, so invest for the long term, and stay the course.

You can’t time the market, so you’d better leave it to the professionals…‘.

But that’s advice given to maximise their fees not your returns!

Now, of course, it’s true that you’ll never pick the exact bottom of the market, other than through blind luck.

But by systematically staging your entry into an investment, you can get close enough to the bottom to safely capture the bulk of the upside.

To make outsized, wealth-creating rates of return, with lower risk…buy low and sell high.

To read more about our coaching programs see here.

Why you should manage your own money

The 3 Cs

There are three excellent reasons to consider managing your own money which we know at the 3 Cs of investing:

Cost, choice, and control.

  1. Cost

The cost of advisory and fund management fees can be very detrimental to returns.

If the ‘average’ annual return from markets is to be about 7-8%, then losing 1% of that makes a colossal difference to your long-term wealth (try putting those figures into a compound interest calculator!).

There’s nothing wrong with paying fees if these costs are helping you to achieve higher returns, but unfortunately in aggregate this has not proven to be the case.

This fact alone makes a great argument for learning the skills to manage your own money.

The fees saved over a lifetime of investing are remarkable enough, but it’s the extra compound growth consequently allowed to flourish which makes for the truly powerful difference.

2. Choice

Most advice is not appropriately tailored to the individual, and most investors and advisors have a ‘home bias’.

But it’s a big world out there, and, because trees don’t grow to the sky, no one stock market can outperform consistently.

In fact, look back through time you’ll find that often the markets that have been the most out of favour over the past year or two become the biggest winners over the following 12-24 months:

Source: Novel Investor

And the research shows that the difference investing in markets which have become very cheap can make to your returns over time is enormous.

Looked at another way, check out the best and worst years in the graphic below for each of the major international stock market ETFs:

For example, the ‘average’ returns from Australian stocks might be about 8%, but this average includes shocking years such as 2008, followed by amazing years such as 2009.

A similar dynamic also applies to emerging markets, and stock market sectors, and investment styles.

The good news is that these days you don’t have to be an expert stock picker, because you can simply invest in a stock market index to capture comfortably strong enough returns.

Fund managers may be reluctant to invest in ‘loser’ markets for fear of looking stupid or losing clients.

But this can be your advantage, allowing you to take full advantage of opportunities as they continually arise in international markets.

3. Control

Mostly advisors will tell you that the best time to invest is right now, and that you must be fully invested all of the time.

But why?

Does that advice help you, or help to generate advisory fees?

Take another look at the worst years in the table above and consider what a 50% loss might mean for your net worth if you’re fully invested in an expensive market.

The key to becoming very wealthy over time is avoiding losses to continue compounding your portfolio and net worth.

And you can do this successfully by thinking of your investments as a series of bets (a strategy known as the Kelly criterion), and by directing those bets towards markets demonstrating value.

By managing your own money you’re free to pick the allocation most suitable for you, your stage of life, risk tolerance, and goals.

Low rates, high returns

The often-quoted ‘average’ returns from stock markets can be a very misleading figure as the graphic above shows.

The average annual return tends to include years of tremendous out-performance (which, for example, we’ll see in 2019), inevitably followed by years of relative under-performance.

Never forget the asymmetrical nature of returns; for example, to recover from a 50% loss then you need a 100% return just to get back to where you started.

When developed markets such as Australia become cheap then, yes, it’s plain sailing: hoist the mainsail and simply let the market bring the great returns to you!

When you’re facing headwinds, however, then you need to work a bit harder.

At this stage in the global cycle, and with many developed markets now so historically expensive, we now believe it makes logical sense to sidestep the potential for significant drawdowns.

The good news is that with an appropriate allocation and a simple rebalancing map, you can achieve comfortably better returns than average through the cycle.

To read more about our coaching programs, see here.

Welcome to Low Rates, High Returns.

Welcome to Low Rates, High Returns

“Rule #1: Don’t lose money.

Rule #2: See rule #1”.

———

Warren Buffett, Berkshire Hathaway.

Net worth: A$125 billion.

This is the first post on our new blog; stay tuned for many more.

Our new book is due to be released in February 2020, and it explains clearly & succinctly the benefits of managing your own money…and exactly how it can be done safely more profitably than you think.

These benefits are what we know as the ‘3 Cs’ of investing yourself:

Cost, choice, and control.

Thanks to the wonders of the internet it’s now quite well known that it’s possible to get average results, simply by doing what everyone else is doing.

But what if you don’t want to be an average person with average results?

What if you want to consistently generate wealth-creating rates of return without the ever-present spectre of significant loss?

To do better than average, by definition you need to think differently from the herd.

For about the past decade, it’s been relatively plain sailing for investors.

Markets recovered from the last crash and went into a secular bull market where real returns have been consistently strong for more than 10 years.

But the price you pay for an investment matters – as Buffett said, what is smart at one price is stupid at other.

Markets move in cycles, so you need to be aware of how to invest accordingly…and safely.

We’re now moving into the rampant speculation phase of the cycle, and it will likely end the same way that it usually does.

Which is to say, not well.

It’s a big world out there, but sometimes an irrational ‘home bias’ limits investors from seeking out stronger (& often safer) returns in international markets.

Why limit yourself?

The good news, as we always say, is:

‘It’s not that hard, honestly!’

Subscribe below to be notified of new posts.

We look forward to sharing your journey to abundant money management.

Short of time? Jump straight to our 8 timeless investment principles here.

Read about how to maximise your long-term wealth guided by the Kelly Criterion here.

To see more about our coaching programs see here.

G’day, from Pete & Stephen; here’s what’s coming…

Hello, it’s Pete Wargent & Stephen Moriarty here from Next Level Wealth.

Our new book will be released in February 2020.

Here on this blog we’ll post some of our thoughts on why we’re getting set for a period of turmoil in some global markets ahead, and how we can position ourselves accordingly to benefit from this.

Over the past 15 years:

  • We’ve developed 8 timeless principles for prosperous investing;
  • Which today can easily be applied successfully to all market conditions at all times (unlike many passive strategies which work some of the time, but fail to deliver at others); and
  • Are proven to deliver robust returns safely through the cycles.

The problem with some passive or ‘buy and hold’ strategies – which generally become popular in bull markets – is that they work in some decades, but not in others.

A timeless investment strategy is not dependent upon market conditions, and is one that will work today, or 100 years from now…or even 1,000 years from now.

Hence, timeless.

What we’ll look to post here on the blog may include:

  • Some of the key concepts from our new book
  • Why a systematic approach to your investing is critical for long-term success
  • Why the oft-quoted ‘average’ returns from investing can be so misleading
  • Why the key to becoming wealthy is not losing money…so you can continue to compound your returns without being set back by significant losses
  • How you can buy low and sell high to deliver above-average results; yes, you can time the market!
  • The risk hierarchy: how it’s become so much easier today to reduce company-specific risk
  • How you can use the inevitable market cycles and mean reversion to make your money work harder (looking both at home markets and internationally)
  • Why market volatility should be your friend, not something to be feared
  • The Enneagram assessment and the ‘9 types’ – the vital role understanding your personality type plays in investment behaviours & results
  • How a regular rebalancing strategy reduces risk in your portfolio, and can effectively force you to buy low & sell high
  • Real-time thoughts on what’s happening in global markets

We look forward to sharing more here with you in the lead-up to our book launch in Sydney in early 2020.

Remember…it’s not that hard, honestly!

By the way, if you’re interested in working together with us directly you can find out more about our coaching programs here.

Cheers, and happy investing,

Pete & Stephen