Occam's Razor

Whew! It’s been a long week, which makes it hard to find time to blog. When I slow down the frequency of my posts, traffic to my site sinks as well. Well, sorry, I’ve been busy. It’s not that I have run out of ideas. I generally blog about whatever is on my mind on a particular day. It does help though to know your market.

This blog attempts to be part education, part inspiration and part entertainment. The education part of it is because I probably spend too much time reading disparate stuff and when I find some wheat in the chaff I feel an obligation to get it out. Inspiration happens less frequently as most of my really good ideas and insights came out years ago. (Fortunately, a lot of those posts still receive regular hits.) The entertainment part is to give visitors a reason to come back. Sex sells, even on my obscure blog, as evidenced by a disproportionate number of hits on my posts on stuff like Craigslist Casual Encounters. Apparently I am vain enough to care about these hits, hence I am more than happy to do a monthly post on Craigslist casual encounter weirdness, or harpoon a recently uncovered philandering politician. I just can’t write about it everyday.

Today money, not sex, is on my mind, mainly because my financial adviser and I have been buying and selling mutual funds. So this post can be classified as education. I keep learning stuff from him and I thought I’d share what I’ve learned about the power of rebalancing.

When I speak of rebalancing, I mean shuffling funds you own around. In the case of my wife and I, these are mostly retirement funds. You may have an IRA or a 401-K and you may have the power to move funds around from one kind to another, say from stocks to bonds. This may not apply to many of you because you don’t have any funds. But you may someday, in which case keep reading. And if you do have some funds, you may learn some new stuff.

So let me ask you. Suppose you had a hundred shares of Google, purchased for an average of $500 a share, and are now worth about $1000 a share. You’ve been watching it trend up regularly with few bumps down. Would you sell it?

Most investors would say, “Hell no!” It’s the human tendency to be greedy, of course. After all, it could go to $1500 a share. 200% return sounds a lot better than 100% return.

Rebalancing a portfolio though is all about selling funds that are making money and putting it into funds that are not. Is that crazy or what? It is crazy, but crazy like a fox, and it is the secret to acquiring wealth for us ordinary mortals not fortunate enough to be Warren Buffet. Of course, most ordinary people aren’t buying stocks. We are buying mostly mutual funds, which are combinations of stocks, bonds and securities, and it is being done somewhat abstractly, probably through our 401-K or IRA plans. We buy mutual funds to minimize risk. Yet the principle remains the same. If you have money invested in a hot mutual fund returning 30% a year, it sounds crazy to take profit from it and invest it in some underperforming fund category, say a CD fund. Why would any sane person do this?

It’s because the only thing that is certain in the world of finance is that nothing stays static. In reality, investing is like playing a game of whack a mole. One fund class/mole gets hit and another one will pop up to replace it. It’s as given a phenomenon as the seasons except when it will happen is unknown. It’s well known that over time that certain kinds of funds pay better than others. Stock funds, for example, generally return more money than bonds over thirty years, although their value may swing up and down a lot. Investors chase profit and they chase wealth retention. Moreover, there is a lot of a herd mentality, at least among professional investors. Many take their cues from channels like CNBC. For the most part these investors aren’t looking ten or thirty years out. They are looking tomorrow, next week or next month. They want to grab some profit now. Investors like you and me though are more likely to want to gain wealth in the long term. We can’t time the market. In truth, financial gurus can’t time the market either. They like to think they can. Anyhow, since we can’t time the market all we can really do to acquire wealth is to intelligently ride the dynamics of the market.

And since the only constant in investing is change, we have to ride change to acquire wealth. So if we have a fund that invests heavily in sexy tech stocks like Google, Microsoft and Apple that has had a good and steady return then we need to sell it when it is profitable. We probably don’t want to sell all of it. There are two parts to this wealth business: gathering more wealth and hanging on to the wealth we have. So typically we own a lot of various fund classes, accepting more risky investments when we are younger and less of these investments as we age. So we can and probably should hold on to that sexy mutual fund, just bleed off some of its profits and put it into something that is not so profitable. We obviously don’t want to invest the money in a class of funds known to be a loser, such as a junk bond fund, but one that is currently undervalued and should become profitable once market conditions change fundamentally. Recessions are not events that might happen, they will happen. When they will happen really cannot be predicted, but when they happen a whole lot of panicked investors will quickly sell their new unsexy assets and buy U.S. Treasury securities and various bonds. We saw this during the Great Recession.

Reinvesting is all about buying low and selling high. If you don’t sell those sexy funds when they are high and buy something undervalued with it, you won’t lock in your profit. And if you don’t lock in your profit, you defeat the whole purpose of investing. The purpose of investing for the average person is not to get rich quickly, it’s to be rich in the future and retain your wealth in the future so you can spend it the way you like.

So that’s what my financial adviser and I have been doing: carefully looking at the value of our portfolio, seeing where we made money and to the extent its value exceeds the percentage we want to be vested in it, putting the profits into well managed funds that haven’t done as well instead. Because when market fundamentals change, as they will, we will have bought those funds when they were undervalued and will be prepared to sell them at a profit, probably for those stock funds that will then be undervalued.

In principle this is quite simple, with the hard parts being picking well-managed, low-fee funds in each asset class. The other part requires patience and discipline: ignoring day-to-day fluctuations and rebalancing regularly.

So it turns out that being a financial wizard is not that hard. You just have to have patience and be a methodical, slow and steady type of investor. You also have to adopt a counterintuitive financial strategy. It’s like driving on the wrong side of the road. Except by not following the crowd, you will actually be on the right side of the road.

Ca-ching!