Learn the Secret of Investing’s ‘Free Lunch’
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You’ve probably heard more than once that “there’s no such thing as a free lunch.”
Everything comes at a cost, or so we’re told. Sometimes that cost shows up on a price tag. Sometimes that cost is hidden.
For investors like us, this shows up as the risk-to-reward trade-off. To get higher potential rewards, we must accept more risk. To reduce risk, we must settle for lower rewards. At least, that’s what they say.
Harry Markowitz famously disagrees.
All the way back in 1952, he said that you can get a free lunch in finance. One very specific free lunch.
We may want to pay attention to what he has to say. See, Markowitz is not some crackpot. He’s a professor of finance at the University of California, San Diego. More importantly, in 1990, he won the Nobel Memorial Prize in Economic Sciences.
And in his words, “diversification is the only free lunch in investing.”
That’s right. Diversifying your investments across industries, countries, and asset classes can decrease your risk — without cutting into your profit potential.
But that’s the easy part. Today there are ETFs galore to help you invest in assets all over the world. And plenty of ways to invest in other asset classes outside the stock market.
The hard part is keeping your portfolio diversified. And that’s where rebalancing comes in.
Let’s dive into this with an example. Think back to Jan. 1, 2020, before COVID-19 hit the headlines, before the lockdowns, the mask rules, etc.
Before the fastest bear market ever.
And before the fastest bull market recovery, too.
Suppose that on that day, you invested $20,000. You put half of it in the S&P 500. To get that free lunch, you diversified by putting the other half into bonds.
Because that was your portfolio plan: to use your stock investments for bigger gains, but to temper any losses with your bond investments. Split 50/50 because of your tolerance for risk.
And hey, it worked. At the bottom of the March 2020 COVID crash, your stock investments were down almost 30%.
But your bond investments fell less than 5%.
Now fast forward to Sept. 16, 2021. At the close, your stock investment was up 38.3% since Jan. 1, 2020.
Your bond investments, however, grew much slower. They were up only 2.49%.
Still, that means your initial investment of $20,000 is now worth $24,079. That’s a 20.395% gain — not bad for 21 months!
That’s all well and good, but it also means your portfolio is completely out of whack. You’re no longer as diversified as you thought.
After all, 21 months ago, you wanted a 50/50 split. And it served you well. Your bond investments kept your principal from dropping too far during the crash.
But now, in mid-September, you’re at a 57/43 split. You’ve gone from $10,000 in the S&P 500 and $10,000 in bonds, to $13,830 in the S&P 500 and $10,249 in bonds.
That means many of the gains you’ve made over the last 21 months are at risk.
And you’re not using your safe-haven bond investments as well as you could.
In short, it’s time for you to rebalance. That simply means selling what you have more of to buy what you have less of, so you can get back to whatever balance you have in mind for your portfolio.
In our example, that means you’d sell $1,790.50 of your S&P 500 stocks and use that money to buy bonds. That would leave you with $12,039.50 in both assets — the 50/50 split you were aiming for originally.
Now, this example is very simplified. A 50/50 split between the S&P 500 and bonds isn’t very diversified at all. You’d need many more kinds of assets from different regions of the world to be truly diversified.
Of course, for readers with access to TradeStops Premium or higher, you can use the Risk Rebalancer tool to do the more complicated math for you. This tool can take any portfolio you have and rebalance it for equal risk per position at the click of a button. If you like, you can even incorporate any cash holdings you have into the equation. If you don’t have access, you can learn more — and get a 79% discount — here.
But the point remains: You want to rebalance your portfolio to “take your wins off the table” and stick to a comfortable level of risk.
And you want to do it regularly; not too much, but often enough. Rebalance too often and you’ll end up paying so much in fees and commissions that you’ll lose money. Don’t rebalance enough, and you’ll end up massively exposed to risk.
Depending on your portfolio, rebalancing once a quarter or once a year might be the best solution. It gives your investments time to move, doesn’t take up too much of your time, and is cheap.
However, that applies to all your investments put together.
If you’re a trader, you may want to rebalance your trading account monthly or even weekly. Stock and especially options trades move quickly enough that you may have to.
On the other hand, for less liquid parts of your portfolio, an annual rebalance is probably enough. I’m talking about things like real estate or alternative investments into wine, art, and so on.
Think of it this way: Investing doesn’t have to be boring — in fact, to be profitable, investing must involve some risk.
But you need to temper the risky parts of your portfolio with diversification. That means also investing in less-risky assets, or assets that have different kinds of risks.
And make sure the ratio between the different parts of your portfolio stays the same. When one part of your portfolio makes it big, take advantage. Sell some of that part and use the money to buy more in the other parts.
Eventually, the winning part of your portfolio will go down, while the other parts will go up. By rebalancing, you’re always in the best position to take advantage — at the right level of risk, to boot.