Investing Is a Rebalancing Act

Intel, whose chief executive, Craig R. Barrett, is shown, lagged this year but could rebound. (Louis Lanzano -- Bloomberg News)

Gains like that hardly inspire exuberance, especially if your investments last year included anything resembling such Dow sectors as mining, up 97 percent; consumer electronics, up 72.5 percent; steel, up 63 percent; Internet services, up 62 percent; or coal, up 55 percent.

With returns like these dangling before investors' eyes, it may seem silly to bother with last year's laggards. Dow sectors with the worst returns in 2004 included semiconductors, aluminum, autos, pharmaceuticals and biotechnology.

But while some sectors will be up and some will be down in any given year, in the long run they all tend to converge to the same long-term average.

It's called "mean reversion," explained Susan Lakatos, a former sell-side analyst and now a chartered financial analyst and certified financial planner working in New York. "It means that investments that do well one year will tend to underperform the market next year."

But it's not quite that simple. The longer a sector outperforms the long-term average, the more likely it is to endure some negative returns before it returns to normal. One sector that may be overdue for some mean reversion is real estate.

Despite persistent talk of housing and real estate bubbles, many investors have flocked to real estate stocks. Real estate investment trusts, or REITs, were one of the strongest-performing sectors in 2003, and after a rough patch in the spring, Vanguard's main REIT index (VGSIX) was up about 23.5 percent in 2004. In addition, REITs can offer dividend yields of 4 percent or more.

But after this kind of run, REIT investors may want to lock in some profits. REITs would likely decline if long-anticipated increases in interest rates finally materialize. Stanasolovich's Legend Financial estimates that REITs, on average, are trading nearly 20 percent above their net asset value. The last time REITS were at similar levels was 1998. In 1999, REIT prices fell 20 percent, he said. So while Stanasolovich is not necessarily predicting a decline of 1999's magnitude, he is reducing exposure to REITs. At the start of 2004, Legend had about 6 percent of its assets allocated to real estate investments; appreciation pushed the allocation up to 8 percent by year's end. So at the beginning of 2005, Legend is rebalancing, selling off real estate to an allocation of less than 6 percent.

So, where should you put the money you made last year in real estate? Balanced investing would favor a sector that has fallen on hard times but has no fundamental impediment to recovery. Consider the semiconductor sector, which was devastated in 2004 as Intel Corp. (INTC), the industry leader, struggled with too much inventory with weaker-than-expected demand for many of its products. Intel shares were down 27 percent in 2004, and some analysts are still not recommending them. But Lehman Brothers Inc. recently increased its rating on Intel from "equal weight" to "overweight." Lehman also has a positive rating on other semiconductor stocks such as Advanced Micro Devices Inc. (AMD) and Qualcomm Inc. (QCOM) but has neutral ratings on Altera Corp. (ALTR) and Xilinx Inc. (XLNX).

To be certain, rebalancing is no panacea and can't be pursued blindly. One year's big gains are not necessarily an automatic sell signal. Take the energy sector, up nearly 33 percent in 2004. While rebalancing discipline would suggest selling some energy stocks going into 2005, there are other factors to consider. First, returns may be up, but that may be because the average return on energy stocks in the 10 years prior to 2004 was lower than the average for all equities. What's more, the price-to-earnings ratios of major oil companies such as ChevronTexaco Corp. (CVX) and ConocoPhillips (COP) are less than 10, which is less than half the overall market's average. (In general, the lower the price-to-earnings ratio, the cheaper the stock and the lower the risk.) Another reason not to sell oil stocks is that oil's dividend can approach 3 percent, above the industry average.

Andrew D. Weissman, chairman of District-based Energy Ventures Group LLC, said the energy sector may need to consolidate some of its recent gains, but he's not taking profits. "We may continue to see some moderate softening over the next several weeks as markets react to swings in the weather." But longer term, he expects higher prices for oil and energy shares. Weissman cites growing global demand with supply that can't be easily expanded.