Remember, the vanilla investor has to pick a mix containing both exciting [eg shares] and dependable investments [gilts]. Boring or bouncy? Whatever lets you sleep easy at night.
Say you pick a 50:50 mix [the balanced portfolio]. When it gets out of line you will need to rebalance - maybe every couple of years. This will mean selling the asset that has outperformed, and buying more of the underperforming one. You sell winners and buy losers.
Now buying into a losing share can be a recipe for disaster - because it could go to zero. (Actually this is true of winning shares too, its why we skip holding individual shares in vanilla investing). But buying into an asset class is not as dangerous. The world global equity markets, taken as a whole, are not likely to hit zero [though there are no guarantees].
Let's look at what happened to Siobhan. She's saving £3000 a year into an ISA and had savings of £30,000, split 50:50 between gilts and shares. Held in a FTSE100 tracker and a medium-term gilts etf.
Siobhan has watched her shares drop 40% in value, her savings are down to £24,000. To rebalance, she should now sell £3000 of her gilts and buy shares. This is tough. She has just watched two-years worth of hard saving disappear in the market falls. It feels like throwing good money after bad.
So what did Siobhan do? Well if she just obeyed the rules, that would be that. But in the real world very few people do stick with a simple set of proven rules. Otherwise we'd all be vanilla investors.
First off , the 50:50 split turned out to be too scarey for Siobhan; 40:60 might have suited her better. Note that a portfolio should be tailored to 'suit' your personality and circumstances more than market conditions. But Siobhan is enough of a vanilla investor to realise that buying when the market is low is better than selling. So she resists the temptation to give up on shares completely and sell out. She is saving for the long term, she is not going to change her strategy every time the market drops.
She still can't bear to sell any of her £15,000 of gilts though, which have been rock steady and such a comfort. So she compromises. She decides to channel all her dividends, interest and futures savings into the 'shares' side of her portfolio. She figures it will take her about 18 months for her monthly savings to push her current £9000 of shares back up to £15,000.
In fact the market rebounded. Within a year and [with the new money she was putting in] her shares were back and more - to £17,000. Time to sell some shares to rebalance ? No - selling £1000 worth to put into gilts is not economic, because of broker's commission and admin charges. Siobhan continues the strategy that suits her - any 'new' money [monthly savings, interest, dividends] she will now channel into the gilts side.
The rules on when to rebalance
'Every couple of years' sounds a bit vague, but in tests its been shown to work ok. In theory rebalancing should happen when the portfolio gets out of balance. That's another simple statement with big implications: there is no timescale. Taken literally you could rebalance every day [big funds do this] or, if you wait for a major imbalance to occur years could go by before action was needed.
As a simple rule - if you have to top up a holding by 25% or more then do it. If your 50:50 split slips to 40:60 then it is time to rebalance. In Siobhan's case suppose her portfolio grows to £40,000, of which £16,000 is in gilts. She should sell £4000 shares and invest in gilts to bring everything back into balance. That's a 25% increase in her gilts holding.
As ever - real life bends these rules a bit. Selling [especially shares] costs money - and should be avoided if possible. Instead, re-direct savings and interest flows. Don't forget, in the accumulation phase of your life [ie while you are working] you will be buying into asset classes over the long term. You will be buying more of everything. Selling is not normal.*
Finally, even the '25% top-up' rule should be ignored if you are only switching small amounts of money - say at the beginning of your savings career. Steve has £3500 in shares, his plan says he should have £2500. Is it worth selling £1000 of shares? In practice - no.
How much is the minimum then?
How long is a piece of string? But since you ask, and you want something practical and simple, and because all our other rules seem to have a a 2 and a 5 in them how about: £2500.
As in - if you are buying and selling stuff over the long run - do it in decent-size chunks. £1 is too little, £5000 is fine, and somewhere in the middle is the minimum you should aim for.
Yeah but why £2500 exactly?
It ain't exact, but its something you should be aware of. If at 65 you look back over your savings career and your purchases have been in chunks of £500 rather than £5000, then commission and charges will add up. Seriously. If you aim to keep purchase costs under 1%, and you get charged £12.50 a trade, and stamp duty is 0.5% then the minimum size order turns out to be......
£2500
Yup
But what if there is no trading charge or stamp duty?
I remember some Irish based funds didn't pay stamp duty, and brokers offering special deals - effectively zero charges if you bought an Irish-based etf. But you can't get round the spread.
Spread?
Even with zero charges if you buy something and sell it back immediately you will have lost money. Because of the difference between the buying and selling price. The spread. Vanilla investors resist making trades incessantly. Charges are one reason, the spread is another. The third is... oh, we'll save that for another time.
Let indolence by your watchword.
*For pensioners [de-cumulators] 'buying' to rebalance is not normal as you are taking money out of your portfolio to provide an income. Here adjustments are made by changing where these cash flows are coming from - taking more from gilts, or shares; and selling holdings over the long term. Rebalancing by 'buying' is the option you would look at last. Just as rebalancing by 'selling' is what you avoid as a saver. Remember to change your mindset when you retire.
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