|
| Emotions should not rule your portfolio |
| John Dorfman / Bloomberg Apr 23, 2009, 00:40 IST |
|
There is one thing my clients occasionally do that makes me want to swallow my tie. I groan when someone lurches between a posture of being 100 per cent in stocks and a panicked retreat in which stocks are abandoned altogether.
Such all-or-nothing investing, driven by emotion, rarely pays off.
A better course is to select an asset allocation you can live with for the long term -- 55 per cent stocks, 35 per cent bonds and 10 per cent cash, for example. Then, rebalance annually to maintain it. You will sleep better, and your investment results might even improve.
That means taking some money out of the stock market when the market is going well -- a step that goes against the natural tendency to keep riding a hot streak.
Even more difficult is the corollary: adding to one’s stock allocation after years in which stocks have been hammered -- 2008, for example. Emotionally, that’s extraordinarily hard.
Like many difficult things, it becomes easier if you make it a habit. If you have established a pattern of taking some money off the table after good years, it’s easier to resist the temptation to become exasperated after a bad year and yank your funds entirely out of the stock market.
Also, if you are in the habit of making an annual strategic adjustment to your portfolio, it will help you avoid the “deer in the headlights” paralysis that afflicts many investors at times of crisis.
Emotional tripwires
Without question, a bear market like this one can hurt your standard of living, and be dispiriting and scary. Yet it is after major declines that the greatest buying opportunities historically have occurred.
Natural human emotions work against a disciplined approach. A great many investors were saying in January and February that they simply couldn’t stand the market’s decline any longer.
By the same token when the stock market was sizzling in March 2000, not many investors had the cool head to pocket profits and walk away.
If you form the habit of rebalancing your holdings once a year, the week of your birthday perhaps, then moving contrary to the waves of the market eventually starts to feel like second nature.
Here’s an example of how an investor might have fared using annual rebalancing over the past 10 years. We will call our hypothetical investor Morris Cohen. Give him $500,000 to invest. Say the date is December 31, 1998.
Stock bond shuffle
For simplicity, we’ll assume that Cohen decides to maintain a blend of 50 per cent stocks and 50 per cent bonds, rebalancing annually on his birthday, which happens to be December 31. He starts with $250,000 in stocks and a like amount in bonds.
The year 1999 was a good one for stocks. In what proved to be the twilight of the technology-driven bull market of the 1990s, stocks rose 21 per cent that year.
Bonds in 1999, by contrast, had a small loss, dropping 0.82 per cent as capital losses slightly outweighed interest payments.
To measure stock-market returns, I’ve used the Standard & Poor’s 500 Index. To gauge bonds, I’ve used the Barcap US Aggregate Total Return bond index.
When the year 1999 draws to a close, Cohen has $302,200 in stocks and $247,950 in bonds. He evens those two sums up at $275,075 apiece and is ready for 2000.
In 2000, the year the Internet bubble popped, triggering the start of a three-year bear market. Cohen’s stock holdings fell 9 per cent to $250,236. His bond holdings, though, advanced more than 11 per cent, to $278,651.
This time the shoe is on the other foot. Cohen pulls some money out of his bond account, and puts it into his stock account.
After 2001 and 2002, the doctor again takes some bond profits and adds a bit to his stock holdings. In 2003 and 2004 the stock market perks up, and the protocol reverses.
Fast forward through 2005, 2006, 2007 and the accursed 2008. When the dust settles, the good doctor has accumulated $658,l65.
Had he simply put the whole $500,000 into the stock market at the start of the 10-year period and left it there, he would have had only $436,059. Had he put it all in bonds, he would have accumulated $864,816.
Allocating assets
For this particular 10-year period, then, an all-bond portfolio would have been the optimal choice. But of course one never knows the answer in advance. And in fact there have been very few 10-year periods in market history when bonds do best.
There are many ways to do asset allocation. The three traditional categories are stocks, bonds and cash. Other asset classes such as real estate, gold, commodities and artwork can be added to the investment blend.
Even more key than the percentage blend you design is the resolve and regularity with which you pursue your annual rebalancing. If it’s done properly, you’ll have enough in the stock market to make good profits when stocks catch fire, and enough in other investments so that your financial foundation won’t be destroyed when stocks have a bad year.
|
|
|
|
|
|
|
|
|
|
 Read Business news in |  |
|
|
|
|
|
|
Advertisements |
|
|
|
|
|
|
|
|
|
Content Guide
