Resisting temptation is the single most demanding task for the "buy-and-hold diversified re-balancers" that make up the bulk of us successful amateur investors.
When we read those newsletters from all the managers that crow about how well their strategies have worked, the temptation to chase yesterday's performance is even greater. We start thinking about how much money we would have had in our own accounts if we had only listened to even one of those guys.
Alas, if only it could be that simple. We know, for starters, that the actual records of those people, as recorded by Mark Hulbert for the past 25 years, illustrates that less than 20 percent of them have ever beaten the market.
It would be nice to follow the 20 percent who had been "winners" by this definition, but how do we know prospectively which ones will be in that rarefied group?
Setting aside the newsletter adviser group, what about our own selection of funds and the temptation of adding a little more money to the ones that have been doing so well in the past few years?
This is nothing more than a different form of temptation, but those of us with a well-diversified selection of mutual funds in our retirement plans are susceptible to this human weakness.
Instead of systematically rebalancing our mix of funds by selling some portion of the winners and buying more of the past losers, we are so tempted to do the opposite -- add to the winners and subtract from the losers. We really experience a smug feeling of satisfaction when we do this because it feels both pro-active and intelligent.
Fortunately for most of us, there is another human condition called "the status quo bias," which prompts us to not touch anything. While this might save us from the statistical disaster of chasing last year's performance, it gets in the way of making constructive, unemotional changes in our portfolio from year to year.
Having issued the above warning on the package, there is a variation of the rebalancing exercise that takes a cue from the trading models of commodities and options traders. This is the phenomenon of letting your winners run and cutting your losses short -- at least temporarily.
According to a Feb. 19 article by Paul Lim of the New York Times, some research done at Standard & Poors has shown that letting a winning fund type run for one year after it has been a winner and then selling it by replacing it with the subsequent year's winner (and holding the latter for a year) actually generated a rate of return that was almost twice what the S&P 500 had earned during a 36-year period.
This is one of the purest expressions of "momentum" investing that works well when markets are going up. The fact that markets have generally seen an unprecedented rise during the past 36 years probably explains why this system looks so good in retrospect.
If we were inclined to do so, how would we incorporate this into our tried and true rebalancing exercise? Instead of selling off a portion of this past year's winning funds to bring our portfolio back to its original balance, we would make note of what the change should have been and effect the change a year later.
If we think back on the days of the tech boom and recall how much our large cap growth funds were rising, this would have meant keeping them for one year longer before selling portions to rebalance. This also would have meant that we would not have been buying more of our "losers" until a year later than we otherwise would have.
What would have happened in such a scenario? Well, in the last four years of the 1990s and first quarter of 2000, we would have had more money earning those spectacular returns. We would not have been buying more of the late '90s "losers" such as REIT funds and small company funds.
Then, in the early part of this decade, we would have had that much more money in those large cap winners that lost 60 percent or more in a year. And we would not have had quite as much in the REIT and small cap funds that have earned an average of 20 percent per year for the past five years -- a period that includes the largest stock market decline since the crash of the 1930s.
We can explore these financial models until we're blue in the face, but at the end of the day, the challenge of pushing the envelope takes time and intestinal fortitude. The temptation to crowd assets into winning funds may start with just a small amount left in what otherwise would have been the subject of annual rebalancing, but the tyranny of success can take hold.
We start confusing brains with a bull market, or a strategy that works temporarily. All we need is a really big loss to drive us out of the market entirely and relegate us to money market returns to perpetuity. We'll be like the generation that never quite recovered from the Depression. We'll be folding aluminum foil so we can reuse it.
The purpose of intelligent retirement plan investing is to improve the quality of life at retirement. Between now and then, the purpose of investing wisely is to gain the satisfaction of knowing that we are on a course that makes sense. That we have put in play a reasonable expectation of risk, rate of return, a rate of inflation and an adequate annual contribution level to a mix of high-quality, low-cost funds.
Any end run around this basic strategy can be tempting, but success ultimately lies with very simple concepts that even the most financially challenged can understand and implement.