Want to Beat the Market? Go Against the Crowd.

When an asset class soars, buying more seems logical. Gold is up, so buy more. And the same "logic" goes for selling investments that have done poorly. Financials are down, so get out.

When an asset class soars, buying more seems logical. Gold is up, so buy more. And the same “logic” goes for selling investments that have done poorly. Financials are down, so get out.

It’s human nature to keep riding a winner and ditch a loser. But it’s usually the exact opposite of what you should do.

Let’s say rising oil prices have caused your portfolio to become overloaded in energy stocks and/or energy-heavy commodity funds. Then, the last thing you should do is buy more. Go against the grain and rebalance. Sell just enough energy stocks and commodity funds to get back to your target allocation.

Energy is just an example. It could be REITS, international stocks, small caps—whatever. When good performance in a certain type of assets causes your portfolio to get too far out of whack with respect to your target allocation for that asset, cut back by selling some of your position.

What should you do with the proceeds? Invest them in assets classes that have underperformed recently and have become underrepresented in your portfolio. For instance, if financial stocks have tanked and become “cheap,” that’s an opportunity to rebalance by taking the proceeds from selling “expensive” energy stocks and commodity funds and redeploying them into the finance sector. One quarter, financial stocks might be the beneficiary of the proceeds. Another quarter, it might be something else.

This is how a rigorous rebalancing protocol works. Instead of relying on emotion, you put mathematics to work for you. You systematically “sell high” and “buy low” instead of the opposite, like so many investors do.

Setting your asset allocation

At my firm, Brinton Eaton Wealth Advisors, we invest in approximately 15 asset classes or sectors, including 5 of the 10 stock sectors defined by Standard & Poor’s. Energy is one of them. The choice of classes/sectors and the percentage to allocate to each are based on expected returns, historical volatility, and correlation (or lack thereof) with the other assets in the portfolio. The right mix is unique to each investor.

We have 10% to 15% of our clients’ total portfolios in commodity index funds that are heavy in petroleum—depending on their overall investment strategy and risk tolerance. We also have 5% to 15% of our clients’ large-cap equity investments in energy stocks.

Everyone who’s investing for the long term needs to have a good-sized stake in energy—both stocks and commodity funds. Still, while energy is a good thing, having too much, which is probably the case in many people’s portfolios, makes it a bad thing. Stay true to your long-term asset allocation, and you will be led to do the right thing, regardless of what others may be doing.

No one can predict when a certain asset type will hit its peak or its low—but with a consistent strategy, you don’t have to worry about predicting the unpredictable. In fact, by rebalancing to your long-term allocation when you need to, you put that unpredictability and volatility to work for you, not against you. That’s how you beat the markets. For example, two asset classes, when rebalanced regularly, can produce higher returns together than the higher-performing class alone. It sounds like a math-defying paradox, but we have the numbers to prove it.

Predicting the market is impossible, but diversification and rebalancing have produced reliable long-term results by both lowering short-term volatility and creating higher returns over time.

Jerry Miccolis, CFP, CFA, is a senior financial advisor specializing in financial planning, investment research, and portfolio management. Brinton Eaton Wealth Advisors is a fee-only financial-planning, tax-advisory, and investment-management firm in Morristown, N.J. Web. Learn more at www.brintoneaton.com.