"Let your winners run" is an age-old investing bromide that means don't sell your winning positions too early. Like so many popular aphorisms, this is advice that works until it doesn't. It relies upon the fallacy that the future can be assumed to resemble the past, one of the most fundamental errors in investing.
For the typical long-term investor, the best practice is to periodically skim off some of the winners and redeploy those assets into the underperformers, a process known as portfolio rebalancing. Rebalancing is one of the most important and least practiced precepts for successful investing over time. The end of another year is a good time to check in on your current asset mix and make simple adjustments that can improve your overall results.
The fact is that investment returns are quite noisy; that is, various sectors or asset classes essentially take turns outperforming each other over time. This is well known; what is totally unknowable is which sectors will outperform next year. Case in point: emerging market stocks were easily the biggest gainers among the major asset classes in 2017, rising nearly 40%. Now suppose you let your winners run into 2018: emerging market stocks turned out to be the worst investment, down 14% for the year. In the event, the best performing bucket in 2018 was cash, but of course that is rarely true and totally unpredictable.
The rationale for holding a diversified collection of investment classes is to address this inherent variability and to smooth out the ride. But while building a thoughtful asset allocation strategy is one critical element, rebalancing the mix is equally important as the actual allocation drifts farther from the target over time. This is a particular risk for 401(k) investors who faithfully contribute to their account but may tend to neglect analysis of their particular mutual fund holdings. Over a five or ten year time frame, retirement investors frequently find themselves substantially overweighted toward riskier assets and therefore more exposed to significant losses in the absence of rebalancing.
The process begins with establishing an asset allocation that maximizes the odds of achieving your ultimate financial goals. If you have not already done so, consider completing a financial plan that allows you to quantify your objectives and helps inform you in constructing an appropriate mix of investment classes. This plan and the resultant asset allocation will of course depend upon a variety of factors including your age, your expected (or desired) retirement date, your tolerance for (or aversion to) risk, and any other relevant factors. A survey conducted by Charles Schwab in 2018 found that only about one in four investors have completed this essential step.
Note that your financial plan and basic allocation should be revisited from time to time as circumstances change and as you progress toward your goals. For example, we tend to become more risk averse as we approach retirement and should adjust our asset allocation accordingly.
Once the hard work is done, let time and compounding go to work on your behalf. Just keep your plan between the guardrails by making the course corrections necessary to maintain your target allocations. Ideally, this is best done on a quarterly basis, or whenever a sector allocation varies from your target by more than 5%. But in reality, if all you do is rebalance once a year, you are likely to be just fine.
Year-end tax planning time presents an excellent opportunity to rebalance. Make a plan, then at least once a year, adjust your holdings back to your target. The rest will follow.
Christopher A. HopkinsChristopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.