Thursday, March 7, 2013

YIPPEE!! We're Making Money!!

The past few weeks have been wonderful for those who are invested in the stock market.  Heck, just the other day I had a meeting with some business partners and one of them went to great lengths to tell me about his “never-lose” options trading strategy.  Last weekend, moreover, I was talking to an artist friend who told me she was about to “get into the market”, so she can accumulate enough money to retire.  Both conversations made me cringe with fear, as the old market psychology of everyone wanting to get on the band wagon, once the parade has started, is unfolding again right in front of my eyes.

 

I’m not saying the market is about to collapse.  To the contrary, my personal belief is that there is still room for this market to go up.  Clearly, a lot of fear remains in the market.  This is especially true, when one considers Europe, our recalcitrant Congress, and the headwinds provided by unemployment and sequestration.  Fear should be holding prices down and, if these issues move toward resolution, I expect investor confidence to be buoyed.  Yet, this tip is not about what you should do now.  It is about what you should always do. 

 

If you are not in the market, should you take all of your money and invest?  The answer is “NO”.  I would recommend that you dollar cost average your way back into the market.  Perhaps being patient enough to wait to purchase your fixed dollar investments on the days the indices will inevitably be worth less.  Dollar cost averaging, while using index investing, could be the answer for you to begin to step back into the market with a minimum of investment risks.  (Check out: http://pfp.missouri.edu/financial/tipoftheweek/efficientindexing.pdf

 

What if you’re already invested  in the market?  First, I say, “Good for you!”  You have demonstrated an understanding of the inevitable ups and downs of market investing and have remained confident in your plan.  Secondly, I ask, “When was the last time you rebalanced your portfolio?”  A well constructed portfolio contains stocks and bonds, of both large companies and small companies; real estate; cash; and et cetera allocated in such a way that you take more risks when you are younger and less risks when you are older.  Yet once we set our portfolio allocation, we need to occasionally revisit it and rebalance our portfolio to assure it stays within our plan.

 

I recently read an article in the T. Rowe Price Investor magazine (December 2012 issue) about rebalancing and what it can mean to you.  The rest of this piece is drawn from this article.  Another good article is from our Security Exchange Commission: http://www.sec.gov/investor/pubs/assetallocation.htm .  Let me turn to the problem…

 

Let us assume you had a portfolio of 60% stocks, 30% bonds, and 10% cash at the beginning of 2008.  Let this be your target allocation.  By the end of 2008, your portfolio would have dramatically changed to 46% stocks, 41% bonds and 13% cash; as stocks lost 37% of their value over 2008, prior to the stock market recovery beginning in 2009.  By 2010, your portfolio would have been 53% stocks, 37% bonds, and 10% cash.  This is closer to your goal, but it is still not what you wanted to own.  You need to sell investments that have increased in value and buy those who have decreased in value, in order to regain your preferred allocation.  Why?  The same article provides an answer.

 

If you compare “no rebalancing” to “monthly rebalancing” to “annual rebalancing over both 10 and 20 year periods, the results are quite pleasing.  Over 10 years, while annually rebalancing to your target allocation, would have resulted in a terminal value for a $100,000 original account of $151,179.  This is compared to $148,019 for monthly rebalancing and $144,574 for no rebalancing.   While this amount is appealing, the spread in the results begins to widen, over the next ten years.   After 20 years, the annual rebalanced portfolio has a $418,422 in the account, monthly rebalancing would have $405,271, and the no rebalancing option only $394,322.  Certainly, a difference in final values of $24,100 was worth the time it took to do the annual act of rebalancing.

 

How do you implement this plan?  If you are adding money to the account, calculate how much more you need to deposit in the “low balance” investments to bring them up to the level you have decided to own.  If you are not adding money, you will need to sell those investments that have become over weighted and buy those who are underweighted.   The good news is that you will be selling investments at a “high” and buying more at a “low” and you don’t have to think about it.  You just have to follow your plan.  If this is too much work for you, pay someone to do it for you.  Many mutual fund companies, asset management accounts, as well as investment advisors, do rebalancing for their clients.

 

As for what type of investments you should have in your portfolio, there are many answers and the absolute truth is that no one size fits all.  What is correct for you may not be what “experts” think, on average, is right for someone of your characteristics.  For an example of a tool to help with general allocation questions, the following: http://www.ipers.org/calcs/AssetAllocator.html was referenced in the SEC document we linked to earlier.


Clearly, you cannot control the market but you can control yourself.  The daily ups and downs will help you, as you implement a rebalancing strategy, for you will be forced to sell winners (sell high) and to buy more of some assets who have decreased in price (buy low).  While nothing is guaranteed, a solid plan with minimal management, is a monumental first-step toward financial success.   

1 comment:

Unknown said...

Great advice. Success comes in focusing your energy on things you can control as opposed to things you can’t. Unfortunately, people expend too much energy worrying about things they can’t control.