Saturday, August 27, 2011

Investment Strategy: How to rebalance a portfolio - The Ratchet Effect

I have explored a few different investment strategies that involve 're-balancing' your portfolio.

I have not, however, run across a clear step-by-step direction for performing this movement. I'd like to share with you an idea about the re-balance of stocks I like to call 'The Ratchet Effect'.

Nuts and Bolts of The Ratchet Effect.

Lets say you are an index investor. You have the following asset allocation, and you invested $10,000 evenly between these indexes.

25% - $2500 - Domestic Canadian Index
25% - $2500 - US Index
25% - $2500 - Emerging Markets Index
25% - $2500 - Total Stock Market Index

$10000 Total.

One year passes. The markets bounce around and shift like a bucking bronco. On the investment anniversary, you check your broker account to see the following balances

$2670 - Domestic Canadian Index
$2240 - US Index
$2845 - Emerging Markets Index
$2618 - Total Stock Market Index

$10373 Total (3.7 % Overall return)

Now, lets say you didn't have any more money to invest. So, you take some money from the 'best performing' index, and apply it to the 'worst performing' index.

This would give us the following allocation:

$2670 - Domestic Canadian Index
$2492 - US Index
$2593 - Emerging Markets Index
$2618 - Total Stock Market Index

We sell $252 from Emerging Markets, which brings it to $2593, 25% of our total value $10373.
Then we buy $252 of US Index, which brings it roughly to the 25% value range that we want all indexes to stay at.
We have Ratcheted up our total value, and purchased more stock in the index that currently has the best value to buy in.

This strategy is cheap and easy.

To improve the return of this strategy, you may investigate adding additional indexes/stocks to the mix.

Please check out Canadian Couch Potato's Portfolio Models to see some good index-based mixes in person.

Remember that this can also work with any portfolio of stocks, but works best with a portfolio that has stocks that will move relatively independently of each other (this is why different countries' major indexes work well).

But Jack, my diversity-poor bank portfolio's stocks are all priced the same!

Don't go into your brokerage account and expect to see large performance differences between your stocks if it's filled with only Canadian Banks, or Telecoms, or Utilities. They would all perform very closely, and you wouldn't get an opportunity to 'sell high' on one of them and 'buy low' on another, as they would be at very similar valuations.

Next time you are looking at your portfolio, check which of your holdings is performing the best, and consider investing it's gains into your most undervalued stock.

Please notice that this is not investment advice. I am an amateur investor, and I only know what I have read from others, which may or may not be completely accurate.

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