Buy and hold might properly be characterized as buy and forget; that's no way to treat your investments. A program of opportunistically rebalancing a strategic asset allocation will enhance yields and help to control risk.
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Strategic global asset allocation, using passive investments such as ETFs and index funds, is the best way to provide asset class exposure to targeted segments of the world's security markets. Ideally, these asset classes should have low correlations to one another, in order to help mitigate some of the equity risk. Additionally, small and value segments in all global markets should be heavily overweighted, to capture additional premiums over the global market index.
When originally modeling an asset allocation plan, you will find you can dramatically increase expected returns, without increasing risk, because the correlations in many markets are so low. This strategy takes global diversification about as far as it can go, using only registered securities that are liquid, totally transparent and fully disclosed. It's a best guess at an "efficient" equity strategy. Of course, you won't know how close you are until you have the advantage of perfect hindsight, 50 years in the future. (For more read 6 Asset Allocation Strategies That Work.)
Diversification and Rebalancing
We all know that diversification is the investor's best defense against specific company, sector, geographic and currency risk. By assigning target weights to each asset class in your investment policy, you exert some control over the total portfolio risk-reward characteristics.
The worst thing that can be said of diversification is that you will never have all your assets in the single worst performing asset class - that's a good thing. Global diversification would have saved investors a lot of grief during the last decade, where seemingly the worst asset class on the planet was the S&P 500.
Of course, you will always have some of your assets in the worst class, and you can never have all your assets in the best performing asset class. This can be very hard for investors to accept and causes them to second guess themselves and potentially lead them to self-destructive behavior.
Ideally, sector weightings would remain static, however, once you actually fund the investments, the various sectors will begin to diverge in performance. Therefore, to hold the risk return characteristics of the portfolio constant, some kind of periodic rebalancing is required, otherwise, over time the portfolio would grow like weeds. It wouldn't take long before your portfolio would bear no resemblance to the investment policy; risk would certainly grow and, more than likely, returns would suffer.
Rebalancing turns out to be a very good thing, indeed. Instead of simply being a maintenance chore to hold the portfolio mix static, rebalancing opens up the possibility of non-trivial incremental gain for the portfolio. (For more, check out Types of Rebalancing Strategies.)
More Advantages Than Disadvantages
Markets have a longstanding, well-demonstrated tendency to revert to the mean. They often move in different directions, fall prey to both irrational exuberance and morbid pessimism, and can overshoot both ways. Eventually they reverse course and revert to something close to a mean. Capturing the benefits of those movements doesn't require a forecast or any kind of market timing decision.
Rebalancing mitigates the fluctuations and captures additional return. It enforces a policy of sell high, buy low, by systematically paring investment gains and redistributing the proceeds to underperforming classes. When those positions reverse, you capture incremental gains. The more diversity there is between the segments, the higher the volatility and the higher the gains. Conversely, during periods of low diversity and/or little volatility, there may be few opportunities to capture.
Unfortunately, a rebalancing policy can be frustrating and counterintuitive to an undisciplined investor. We know from watching cash flows in investment markets, that far too many investors chase recent investment returns, buy high, sell low, repeat the process until broke and then wonder why they can't make money in the capital markets. While they know better, they are almost hard-wired to fail as investors. Somehow this self-destructive behavior is psychologically rewarding, while financially disastrous. On the other hand, a rebalancing discipline reinforces good behavior and should lead to far better outcomes; it's not satisfying, but it is profitable. (For more read: Portfolio Rebalancing Made Easy.)
Rebalancing in Practice
Perhaps the best example comes from the run up of the S&P 500 and Tech Funds, just prior to 2000. A specific investment policy called for a 10% of equity allocation to the S&P 500 and no specific Nasdaq or Tech Sectors. While a mindset developed that those sectors could only go up forever, investors systematically sold the S&P 500 to keep it in the specified allocation.
In this case, the risk of concentrated positions and failure to properly diversify, became painfully apparent. During the 2000 to 2002 time period, the equity portfolio lost less than one third of what the S&P 500 did and subsequently snapped back faster and further. Therefore, even if during the 1997 to 2000 period the portfolio looked like a loser, over the entire period from 1995 to 2010 it was a winner.
The Bottom Line
In fairness, such a diversified portfolio wouldn't have insulated investors during the recent market meltdown, where there was no place to hide, as investors fled to quality. However, those clients who had the financial resources and stomach to systematically purchase equities, by rebalancing between their fixed income and stock positions, would have had gratifying gains on those rebalanced positions. (To learn more about portfolio management read: Portfolio Management Pays Off In A Tough Market.)
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