<<Prev Next>>

Buy-Only Rebalancing

Spice up investing with leveraged ETFs or selected stocks


The Human Factor

The "Buckets"

Increasing Risk

Decreasing Risk

In this section we take a look at some options for adding fun, the potential for higher returns, and (of course) risk to the basic plan.

Increasing risk is not a necessary part of Buy-Only Rebalancing but is an optional and complimentary strategy. If you will need your money within a few decades or you have no interest in learning about markets and investing, you should probably just skip this section.

When to increase risk

Investing is full of unknowns. Many investors make the task unecessarily difficult by trying to benefit from predictions about the movement of a stock price or the movement of the market as a whole. Usually, the difficulty is fourfold when one tries to profit from predictions.

  1. The right investment vehicle must be chosen.

    If an economic idea is correct, choosing the right security or derivative to buy or sell might not be straightforward. If one thinks ethanol is about to be banned, what should be bought or sold? Maybe corn futures should be sold, but what contract? Or maybe a spread would be better? But what kind of spread? A bear spread constructed from put options on futures contracts? An intercrop spread, where a short-term contract is bought or sold and the opposite longer-term position is taken? An intercommodity spread, where corn futures are sold and another commodity is bought? Maybe a butterfly spread would be better? Maybe not! It can be a tricky business deciding.

  2. The right direction must be chosen.

    Prices can increase, decrease, or "move sideways" (often going up and down between a higher and lower price, called a "trading range"). It is possible to make money from any of the three, but it is only easy to know which of the three is going on in hindsight, when the opportunity has passed.

  3. The right entry time must be chosen and achieved.

    Although it isn't a big problem when investing on a long-term time scale, attempts to profit from intraday or day to day price changes can be thwarted by delays in the execution of buy or sell orders.

    Trades of popular stocks and ETFs are not much of a problem, but options and non-stock investments like cocoa futures have many fewer trades going on at a given time. If nobody wants to trade with you, this lack of liquidity is a risk to consider.

  4. The right exit time must be chosen and achieved.

There is a significant danger that a small profit obtained when all of these factors come together may be nullified by overhead like commissions and bid-ask spreads. "Breaking even" is only possible when there is enough profit to pay for the trading.

To minimize the weight of these factors, all of which involve unknowns that can eat money, I try to exploit knowns. There are few knows, but one is important: a decline in prices that has already taken place.

When prices go down, you are certain that they've gone down. Now there's no guarantee they'll go back up, but if it's the price of an ETF like IWV, and if you're investing with an eye to cashing out decades in the future, then you only need a little faith. The assumption of Buy-Only Rebalancing is that over the course of decades, the stock market in general will go up.

Leveraged ETFs

With that fairly conservative assumption in place, it makes sense to increase risk a bit by buying aggressively when prices go down significantly, like when the Dow Jones Industrial Average goes at least ten percent below its last peak. One easy way to do so is to purchase shares of a leveraged ETF like SAA , which moves twice as much as the S&P 600 Small Cap Index. That index tracks six hundred small-cap stocks.

It's worth reading the prospectus for a leveraged ETF and making sure you understand it, as FINRA points out, because a leveraged ETF usually tries to double the move of the underlying index on a daily basis, and you should know how that affects its relationship to the index for longer terms. If you pick an ETF that has been around for a while, you can use the adjusted price in Yahoo!'s historical prices to make sure the gain or loss is about twice the gain or loss of the underlying index for the same time frame, but as fund sellers are required to say, past performance does not guarantee future results. The proshares site has a great online explanation of the effect FINRA wants you to understand.

Buying leveraged ETFs introduces more volatility into your portfolio, increasing risk, with the expectation that the eventual long-term increase of the market in general will have a bigger profitable effect.

Increasing risk like this is a supplemental and complimentary strategy to Buy-Only Rebalancing, and it might be prudent to sell these leveraged ETFs when prices go up. Of course, judging how far up is "far enough" is not easy, but you might find it fun. Presumably you'll use the proceeds of the sale to fill the bucket with the lowest level.

Selecting individual stocks

Some very smart people say that picking stocks is not a bad idea within one's own areas of expertise. Warren Buffett has had a great deal of success by investing in high-quality businesses that he understands. He emphasizes that a business should have a "moat", something that protects it from competition.

Peter Lynch has a nice book called One Up on Wall Street: How to Use What You Already Know to Make Money in the Market. Like Buffett, he recommends sticking with what you know. Lynch explains how your expertise gives you an advantage in selecting certain stocks—the stocks your own life experiences help you to evaluate.

If it's possible for normal people to select stocks, and I believe Lynch is correct in arguing that it is, then when market prices in general have gone down, individual stocks are another interesting option for accelerating the Buy-Only Rebalancing system by increasing risk.

As to the question of when to sell individual stocks, I tend to periodically investigate the ratios at reuters.com for the companies I'm interested in.

Understanding these ratios seems intimidating at first, but with the help of investopedia.com I was able to use them after a week or two of casual evening study.

The ratios allow you to quickly evaluate the health of a company. This Fundamental Analysis is like the evaluation of "vitals" that a hospital doctor does. A sick company should be sold, especially if its price has risen since you purchased its shares and if you don't have any reason to anticipate its financial recovery.

Picking stocks is fun but again introduces risk and volatility into your portfolio, and so it should be done in moderation if at all. Personally, I enjoy it when the market has declined as a way to invest the cash that has accumulated from dividends and interest.

Boom and Bust

Sometimes in the middle of a long bull market, it isn't easy to wait for a dip in prices. It seems like prices are going up and up, and opportunities to make a lot of money are passing by. Unfortunately, this feeling leads investors to do the opposite of smart investing: being more aggressive when prices are at their highest. Instead, you can cultivate patience by keeping in mind the boom and bust cycle.

George Soros does a nice job of analysing the behavior of boom and bust cycles, and he has some good explanations for why they come about, but it is heavy reading. I enjoyed The Alchemy of Finance, but it was a difficult book for me, at least in parts.

But even without a profound understanding of boom and bust cycles, a quick survey of economic history suffices to show that they are real and periodic, and that when things look great one is probably just a year or a few years away.

For that reason, patience is a great goal for any investor interested in aggressive investments. After the next crash, there will be plenty of things to buy, and they'll be a lot cheaper. Until then, stick to lower-risk investment options, and if you're really ambitious, save up some cash so that you can buy like crazy when the bear market finally comes.

The next section talks about strategies that complement Buy-Only Rebalancing in order to lower risk. Lowering risk can be a great idea for anyone at any time, but it is especially attractive if you feel the end of a boom is near, or if you will need your funds sooner than a few decades from now, or if a more aggressive investment has made a good profit and you want to "cash out".

<<Prev Next>>