2013 has been a great year for investors in the stock market, with gains of around 25 percent for the Dow Jones industrials (^DJI) capping off a five-year bull-market rally. Many investors who had the discipline to hold their stocks after the market’s plunge during the financial crisis in 2008 and early 2009 have seen their portfolios recover to their pre-crisis levels — and keep climbing.
But if you want to preserve your investment gains, you need to learn from the mistakes of the past.
Specifically, there’s one crucial money move you need to make to realign your portfolio with the appropriate level of risk that you can afford to take with your investments. That move is rebalancing your portfolio.
The Basics of Asset Allocation
Many investors use a method called asset allocation as the basis for their overall investing strategies. Asset allocation involves breaking your portfolio into several pieces, investing each portion in a different type of investment.
Traditionally, investors split their assets across stocks, bonds, and cash, coming up with asset allocations that reflected their relative risk level. Riskier portfolios included higher percentages of stocks, while more conservative investors prefer greater allocations to bonds and cash.
For instance, investors with middle-of-the-road risk tolerance but without any need for a separate cash allocation might choose a 50/50 split between stocks and bonds, giving them growth potential from their stocks and reliable income from their bonds.
Asset allocation strategies are simple and easy to follow, but they require some attention to make sure that they stay in balance.
Over time, different types of investments will produce different returns. If one investment soars in value while another plunges, then you’ll quickly find yourself with more of the better-performing asset than you originally intended. That might sound ideal, but it actually creates risk that you might not even know is there until it’s too late — unless you rebalance.
How Investors Got Burned in 2008
We saw the downside of the risk of unbalanced portfolios during the bear market of 2008. Between early 2003 and late 2007, the stock market almost doubled. That was obviously a positive for the value of their investment nest eggs. But an unintended result was that many of those who had neglected rebalancing their portfolios found themselves with much larger allocations to stocks than the target allocations in their personal investing strategies.
When the stock market started to fall, the heightened level of risk in those investors’ portfolios became apparent. With stocks falling 37 percent in 2008, even those who had thought they had conservative allocations to stocks found themselves with losses of 20 percent or more. With rebalancing, these investors wouldn’t have avoided losses entirely, but they would have reduced their impact and made it easier to recover from the market’s collapse.
Will History Repeat?
Since 2009, we’ve seen an even more dramatic move in stocks, with the SP 500 (^GSPC) needing to rise less than 10 percent further to triple its worst levels during the bear market five years ago. That has sent stock allocations through the roof for those who haven’t rebalanced their portfolios.
Moreover, even for those who are diligent about rebalancing, 2013 has been an extreme year for portfolio balance. During much of the mid-2000s, stocks and bonds rose together, limiting potential imbalances. In 2013, though, bonds have fallen at the same time that stocks have soared, and so even in the space of a single year, a 50/50 portfolio has seen its stock allocation rise as high as 60 percent.
What To Do
Rebalancing your portfolio isn’t a complex process. The simplest way to do it is to refer back to your target asset allocations, add up the investments you have in stocks, bonds, cash and other assets, and then run the numbers to figure out where you need to cut back and where you should add to your positions. This year, what you’ll likely find is that you’re selling stocks at record highs — just about the perfect answer to follow the mantra of buying low and selling high.
Another method works if you’re adding money regularly to your investments. Rather than allocating new savings according to your asset allocation percentages, you can put all of your savings toward whichever type of investment is underweight, helping boost its share of your overall portfolio. Depending on how much savings you have, this method might go too slowly for your comfort, but it’s also useful if you don’t want to sell investments and generate tax liability.
Whichever way you do it, though, don’t skip rebalancing your portfolio this year. With such a strong stock market, failing to see the danger of a future market drop before it’s too late could cost you a big portion of the profits you’ve earned from your investments in recent years.
Warren Buffett is a great investor, but what makes him rich is that he’s been a great investor for two thirds of a century. Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.
Most people don’t start saving in meaningful amounts until a decade or two before retirement, which severely limits the power of compounding. That’s unfortunate, and there’s no way to fix it retroactively. It’s a good reminder of how important it is to teach young people to start saving as soon as possible.
Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That’s really all there is to it.
The dividend yield we know: It’s currently 2%. A reasonable guess of future earnings growth is 5% a year. What about the change in earnings multiples? That’s totally unknowable.
Earnings multiples reflect people’s feelings about the future. And there’s just no way to know what people are going to think about the future in the future. How could you?
If someone said, “I think most people will be in a 10% better mood in the year 2023,” we’d call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.
Someone who bought a low-cost SP 500 index fund in 2003 earned a 97% return by the end of 2012. That’s great! And they didn’t need to know a thing about portfolio management, technical analysis, or suffer through a single segment of “The Lighting Round.”
Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7% of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average long-short equity hedge fund produced a 96% total return — still short of an index fund.
Investing is not like a computer: Simple and basic can be more powerful than complex and cutting-edge. And it’s not like golf: The spectators have a pretty good chance of humbling the pros.
Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility. Yet every time — every single time — there’s even a hint of volatility, the same cry is heard from the investing public: “What is going on?!”
Nine times out of ten, the correct answer is the same: Nothing is going on. This is just what stocks do.
Since 1900 the SP 500 (^GSPC) has returned about 6% per year, but the average difference between any year’s highest close and lowest close is 23%. Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring.
Someone once asked J.P. Morgan what the market will do. “It will fluctuate,” he allegedly said. Truer words have never been spoken.
The vast majority of financial products are sold by people whose only interest in your wealth is the amount of fees they can sucker you out of.
You need no experience, credentials, or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention he’ll receive, even though it makes him more likely to be wrong.
This is perhaps the most important theory in finance. Until it is understood you stand a high chance of being bamboozled and misled at every corner.
“Everything else is cream cheese.”