Can trees grow to the sky? This stock market's astonishing rate of ascent has given pause even to people like me who think investors should buy and hold.
I'm not about to change my tune. I haven't a clue whether stocks are going to rise or fall over the next 12 months.
But fortunately for scaredy-cats, there's a prudent theory of profit-taking that fits neatly with buy and hold. It's called "rebalancing."
Careful investors make a deliberate decision about what percentage of their assets to hold in stocks. The decision should turn on how big a risk you want to run.
For example, take a company 401(k) plan that started out with 60 percent of its money in stocks and 40 percent bonds.
Since 1950, that 6 0/4 0 mix of stocks and bonds has yielded a 10.7 percent average annual return, according to the New York investment advisory firm, Towneley Capital Management. (Towneley used Standard & Poor's 500-stock average as a proxy for stocks.)
In its worst 12-month period, this hypothetical 401(k) plan would have lost nearly 25 percent. By creating a 6 0/4 0 mix, you've implicitly said that you could handle such a loss.
But since you started this plan, the stock market has soared. When you figure its value, it might turn out that stocks now account for 70 percent. That raises your level of risk.
Since 1950, a portfolio made up of 70 percent stocks and 30 percent bonds has yielded an average annual return of 11.4 percent, Towneley says. But in its worst year, this mix of assets lost more than 28 percent.
Maybe you don't want to face losses larger than 25 percent. So you'd rebalance your portfolio, bringing it back to its original mix of 60 percent stocks and 40 percent bonds.
That means selling some stocks and reinvesting the profits in bonds.
Another form of rebalancing might occur within the stock portion of your portfolio.
When you started, you might have decided to hold 80 percent of your equity investments in the United States and 20 percent abroad.
But international stocks have lagged. The U.S. portion of your portfolio might be up to 90 percent.
To rebalance, sell some of your U.S. stocks and put the proceeds into international investments.
The act of rebalancing takes money out of assets that have risen in value and reinvests it in assets that are relatively underpriced. Lo and behold, you are selling high and buying low, just as the market gurus say you should.
Rebalancing isn't intended to improve your stock market returns. In fact, it might not.
But it reduces your risk. When the U.S. market finally falls, you won't be as exposed as you are now. Furthermore, you'll make money when the underperforming part of your portfolio starts moving up again.
As a practical matter, not every investor will find it easy to rebalance. It's principally done by people who buy no-load (no sales charge) mutual funds.
With no-load funds, there's no cost when you switch from one investment to another. Also, you don't have to decide which particular stocks to sell. You sell shares in your funds and switch the money into bonds.
Rebalancing also works best in tax-deferred retirement plans. If you have to pay capital gains taxes when you sell, you'll have less to reinvest.
You can't tell which is going to cost you more, selling shares and paying the tax or enduring a stock market decline. If you're truly a long-term investor, however, you might prefer to wait it out.
Here's how to rebalance when taxes are an issue: Hold the shares you have and put any new money into the asset that has underperformed -- in this case, bonds or international stocks.
Another strategy for investors who buy and hold is to look at markets in trouble. Right now, that means many markets in the Pacific Rim.
Some of those boom economies have flagged, due to slowing profits, excess manufacturing capacity and shaky banks. Several currencies have tumbled against the dollar, causing losses in mutual funds that invest in those emerging markets.
There's no telling how much more serious those losses will get. But if you can hold for 10 years or more, emerging markets funds are an interesting speculation right now.