IFM Re-balancing and Mechanical Management

History has demonstrated that businesses, economies, and societies evolve through a fairly consistent cyclical pattern.  The basic cyclical pattern moves between boom and bust, highs and lows. As a result of the economic, business and societal cycles, investment markets also move in a similar cyclical pattern, with peaks and troughs. These investment cycles are a natural condition as investors shift the allocation of their savings between the different financial asset categories. 

Over the past few decades the accepted approaches to investing within these cycles have evolved into a very passive, almost inactive approach that accepts the peaks and troughs of investment markets, but believes that over time investment markets always rise in value. Today, most investment approaches therefore council investors to simply Buy and Hold (or as some would say Buy and Hang-on) because it preaches that "no one can predict future markets and no one can successfully trade the peaks and troughs." Our approach keeps faith with the first part of this belief, but we also dislike watching the value of our savings rise and fall at the whim of the financial markets. As a result, the IFM Approach is more proactive when it comes to managing and securing our investing profits. We are not afraid to safeguard our savings and profits, and if we miss out on potential future gains in the process, so be it.

Note: InvestingForMe accepts that the investment markets move through peak and trough cycles and we accept that investing involves the unknowable future. As a result, we have structured our approach to focus on our established target asset allocation. In other words, we always try to remain focused on maintaining our portfolio's current asset allocation at or under our target asset allocation. If our target asset allocation is 65% invested in Fixed Income investments and 35% in Growth investments, then we always work to ensure that our investment portfolio is invested at these levels. At certain times within a stock market cycle, we may maintain a lower allocation than 35% in the Growth investments.

Within set mechanical guidelines, our investment portfolio is rebalanced toward our target asset allocation at all points within the investment cycle. A few of our general re-balancing rules are as follows:

  1. Set re-balancing guidelines that are mechanical in nature. The guidelines are independent of current investment market directions, investment industry recommendations and current investment trends. 
  2. For individual Growth investments, allocate equal dollar amounts for each individual investment and re-balance toward the set, equal, dollar amounts.
  3. For Fixed Income investments, allocate equal dollar amounts for each individual investment and re-balance toward the set, equal, dollar amounts.
  4. Profits from Growth investments are always reinvested in Fixed Income investments. When re-balancing profits from Growth investments, reinvesting them in Fixed Income investments always safeguards the crystallized profits. Profits from Growth investments are never kept at risk by reinvesting back into Growth investments.
  5. When re-balancing due to a decline in the value of the portfolio’s Growth assets, Fixed Income investments are reduced and the proceeds are allocated to the individual Growth investments. Re-balancing from Fixed Income investments into Growth investments only occurs as a result of a declining investment cycle, not because of the deterioration in a single Growth investment. Do not reinforce failure in a single investment!
  6. Before adding Fixed Income funds to Growth investments always reassess and reconfirm the Growth investment’s financial health, its market share within its industry and its industry’s future prospects. Never allocate Fixed Income funds to a Growth investment with deteriorating fundamentals. Do not reinforce failure!
  7. Experience shows that if you buy 16 Growth investments today, over the next investment cycle, 4 of them will exceed your expectations, 8 will meet your expectations and 4 will disappoint. Never be afraid to sell the investments that disappoint.
  8. Maintain the confidence and discipline to adhere to the re-balancing guidelines. Do not second-guess the act of re-balancing. Remember these two rules:  no one knows what the future may hold, and no one ever goes broke securing a profit.

We will use a simple example to illustrate what we mean by focusing on our target asset allocation to re-balance.

Example:  If we have established a target asset allocation that is 65% invested in Fixed Income and 35% invested in Growth investments, then this is the standard that our portfolio is always rebalanced toward. This is the asset allocation that we ideally want to have at cycle peaks and cycle troughs.

For example, as the investment markets rise toward their cycle peak, the investment portfolio is rebalanced by selling a portion or all of a winning Growth investment and reinvesting the profits in Fixed Income investments. Conversely, as the investment cycles declines toward its trough, the investment portfolio is rebalanced by selling a portion or all of a winning Fixed Income investment and the proceeds are reinvested in Growth investments.

Remember: Re-balancing an investment portfolio’s asset allocation is just as important in the trough portion of the investment cycle, as it is at the cycle’s peak.

The frequency of a portfolio’s re-balancing can vary from one investment portfolio to another. The re-balancing frequency will be influenced by the portfolio’s asset allocation, the investor’s personal financial circumstances and their financial goals.

Three general re-balancing rules include:

Members' Note: In general, InvestingForMe uses a quarterly review and re-balance frequency for its Sample Portfolios, subject to the three rules above.

Most investors that subscribe to a pure Buy and Hold investment approach often suffer tremendous swings in the market value of their investment portfolio. They might have the same 65% - 35% asset allocation, but without a disciplined, consistent re-balancing process the value of their portfolios experience much greater swings.

Example:  If a Buy and Hold investor starts in the trough part of the cycle with a 65% - 35% asset allocation, without regular re-balancing, at the peak of a cycle their asset allocation might become 50% - 50%. Going into the next trough cycle, their portfolio is heavily exposed to the deteriorating investment cycle.

Remember: Establishing guidelines for the re-balancing of the investment portfolio are easy. Finding the confidence and discipline to adhere to those guidelines can be extremely difficult.

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