A New Twist On An Old Strategy That Works

We all know we're supposed to "buy low, sell high." That's easier said than done, of course. But rebalancing is the next best thing. And it works...

To put it simply, rebalancing calls for bringing a portfolio back to its original asset allocation mix.

If you think about it, over time some assets in your portfolio will appreciate faster than others. And let's face it -- some will even decline.

Rebalancing brings your portfolio allocation back into alignment. There are a number of reasons to do this. Let's look at a hypothetical example to better understand...

Let's say you open an investing account. You decided that the ideal allocation for your portfolio is 50% U.S. equities and 50% bonds. (Note: The exact portfolio allocation for stocks, bonds, and cash should largely depend on your own time horizon and risk tolerance. Nobody knows your situation better than you do.)

Now, a year passes by. The stocks in your portfolio did well. But they now occupy 55% of your portfolio. This is partly due to some stocks that did well, but a few of your bond holdings also underperformed. You might be okay with this for a year. But if left unchecked over time, you may find yourself with a portfolio that is way out of whack relative to what you intended. You may check your portfolio a few years down the line, only to find it suddenly way "overweight" on equities -- so much so that you're uncomfortable owning that much in stocks.

This is why it's a good idea to rebalance periodically. If you haven't considered rebalancing already, a new calendar year is a great time to do it.

As referenced earlier, one way to rebalance is by selling off a little bit of your highest-performing stocks at the end of each year and scooping up shares of underperformers. Not only does this rebalance the portfolio, but it can also result in a higher portfolio yield. Let's look at the popular Dogs of the Dow strategy to see how this works.

Meet The Dogs Of The Dow

At the beginning of the year, investors following this strategy buy the 10 highest-yielding Dow stocks. On the last trading day of the year, they sell and then buy the new highest-yielding Dow stocks.

The logic behind the Dogs of the Dow strategy is two-fold. First, it relies on the idea that the Dow Jones Industrial Average represents inherently sound stocks that will (eventually) come back. Second, those stocks' higher-than-average dividend yields mean they are oversold.

Essentially, this strategy is a bet that the underperforming stocks with the highest yields are likely to be at or near the bottom of their business cycle, and that their currently depressed prices (and abnormally high dividend yields) won't last. The resulting portfolio has a higher yield than the Dow.

Sounds good in theory, but does it work? Well, with the decade of the 2010s just coming to a close, this is an opportune time to review.

A portfolio comprised of the 10 highest yielders in the Dow Jones beat the overall Dow in seven of the past 10 years. Overall, the Dogs delivered an average annual return of 15.0%, outperforming the 13.4% return of the Dow by 160 basis points. So while the Dogs strategy may be considered "old school," it clearly works. Oh, and in case you were wondering, here are the official Dogs for 2020...

Putting The Dogs To Work

Now, this is all fine and good. But rebalancing requires discipline – unfortunately more discipline than most investors possess.

Luckily, there's a solution. There are a number of ETFs that follow a similar strategy. One of my favorites is the ALPS Sector Dividend Dogs ETF (NYSE: SDOG).

SDOG applies the same "dogs" concept. But instead of being limited to old-school Dow Jones companies, the fund tracks the five highest yielders within each of the 10 sectors of the S&P 500 (for a total portfolio of 50 stocks). That includes the five highest-yielding tech stocks, healthcare stocks, real estate stocks, etc.

And here's the nice thing about SDOG... The ETF rebalances quarterly, taking whatever discipline we may (or may not) have out of the equation.

There is more to this strategy than just putting extra dividends in your pocket. Yields are equally tied to distribution levels, so you're also investing in companies with rising cash flows that are lifting payouts.

With value out of favor relative to growth, SDOG has struggled to keep pace in recent years. But the tide has begun to turn. The fund (which offers a healthy yield of 4%) posted a gain of 24% last year and is well-positioned to deliver attractive gains again in 2020.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.