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I wrote a post a while ago about the Myth of Diversification – just another piece of financial ‘wisdom’ almost designed to keep you form retiring early / retiring rich …
Yet, despite the current melt-down that should prove that there is no real safety in diversification, the principles remain as mainstream as this comment from Francis illustrates:
That’s the idea behind diversification and re-balancing. If you invest in multiple things and periodically adjust the balance between them you are forced to buy low and sell high.
It really doesn’t take a genius to make a few million if you can just buy low and sell high …
… but, it takes genius to know when to buy low and when to sell high!
Who knows where ‘high’ and ‘low’ really sit: they are relative, which serves (partially) to explain why market timing doesn’t work!
As the Dalbar Study shows: mere mortals should not be in the business of trading stocks / timing the market; people who attempt this reduce their returns from 11.9% to only 3.9% … !!
No, we are simply investing for the long term, that’s why I asked Francis:
I agree with the “buy low” part … but, why “sell high”? Warren Buffett got rich by not selling his winners … he holds on to them.
Quite rightly Francis responded by pointing out that we aren’t Warren Buffett, saying:
Another reason to sell is that there are bubbles where the valuation of particular resources is out of whack. Wouldn’t it be a good idea to sell off at some amount before the peak of the bubble then repurchase after the crash? If you could reliably time the market you would sell it all at the peak and buy at the trough. I don’t have a crystal ball and I’m terrible at market timing. I’ve accepted rebalancing as a reasonable compromise.
As for Warren I know his favorite holding period is forever, but he is buying individual companies and is really good at valuing companies. He avoided the internet bubble like the plague, but I suspect that if he had stocks that became wildly valued he would sell them off.
But, if we really aren’t Warren Buffett, how do we KNOW when “the valuation of particular resources is out of whack”? Well, according to Francis, that’s when ‘rebalancing’ comes into play …
But, how does re-balancing provide a ‘reasonable compromise’ to the fact that we are all (WB aside) “terrible at market timing”:
Let’s say that you have $100,000 invested: 50% of your money invested in stocks and 50% invested in bonds.
Let’s then say that stocks ‘devalue’ by 50% overnight (a huge market crash) … in the case of an Index Fund, this could simply be a cyclic response to the market that has occurred many times in history.
Suddenly, your portfolio has shrunk by $25,000, so now you have $25,000 worth of stocks at post-crash prices and $50,000 worth of bonds (their price/value hasn’t shifted in this hypothetical crash). That is, you have 33% in stocks and 67% in bonds … so what do you do?
Well, you buy $25,000 more stocks … or, do you sell $25,000 of bonds?
The reality is that most people don’t have the $25,000 in ‘loose change’ to rebalance by topping up their portfolio, so they shift money FROM bonds INTO stocks.
Yippee … except, what happens when stocks recover and/or bonds dip?
In that case, you’d be taking yourself OUT of the stock market (a 9.2% – 11.9% annualized return, depending on who/how is doing the measuring) into the Bond market (a 4% annualized return?) …
… a forced flight away from stocks!
Would Warren Buffet do this?
Heck no! Warren Buffett doesn’t worry about market dips; he knows the market always recovers, as long as the underlying businesses keep making money. In fact, he looks at market dips as a buying opportunity (didn’t he load up on Kraft, while we were all bailing out of the market).
He identifies quality when he buys (bet he didn’t own any Enron), but, he recommends that you buy a little piece of all of America’s finest companies (a.k.a. an Index Fund, so even if you do happen to buy Enron, it’s only a tiny sliver of what you own), if you don’t know how to do what he does.
Warren doesn’t ‘rebalance’ his portfolio into cash (no dividends even, because cash/bonds doesn’t produce as high a return as his investments can) … and, he certainly buys more when the market dips and NEVER sells.
Here’s what to do:
If stocks are the asset class that you like and if you think that the stock market (as represented by an Index Fund or one or a few individual stocks, if you prefer) represents acceptable value:
1. Buy stocks … as many as you can afford; and,
2. Keep buying whenever you can afford more; and,
3. When the market dips, it’s ‘on sale’ … buy even more; and,
4. Never sell.
That’s it … now you are Warren Buffett.