Don't Buy and Hold; Buy and Re-Balance

Almost all investors are aware of the advantages of diversifying their portfolio.  By diversifying we mean investing in various asset classes (small caps, large caps, bonds, cash, real estate, etc.) in the expectation that the price of every asset class will not move in the same direction at the same time.  The historical advantage to this is the fact that while one asset class has gone down in price another one has usually been going up.  Those who were completely (or nearly so) invested in stocks during the stock market decline of 2008-09 lost more than those who were better diversified. For example a portfolio invested entirely in stocks lost about 45% during that period, while one invested 50/50 in stocks and bonds lost only 25%.  Historically diversifying one's holdings has proven beneficial to investors.

Another tactic can add even more to the advantages offered by diversification.  This is the practice of rebalancing the portfolio after it has moved off of your desired allocation.  The first step in this process is to determine exactly how much risk one is willing to take.  The more one has invested in riskier assets like stocks, the more volatility and risk they will be exposed to in the market.  Thus, a portfolio invested 40% in cash and bonds and 60% in stocks has historically been less volatile (experienced smaller swings in value with market fluctuations) than an all stock portfolio.  So let's suppose that an allocation of 40%/60% bonds to equities reflects our desired risk profile, and we allocate our holdings to reflect this.  As time passes and markets move one way or the other, our desired allocation will eventually drift off of our desired target. If equities have moved up sharply, we may find that our portfolio has evolved so that we now have only 35% of our total holdings in bonds but 65% in stocks.  Our allocation target would dictate that we take 5% from our stock holdings and move it to the bond portion of our holdings.  With this discipline we are forced to invest in the asset class that has increased less, or declined in value; it is a type of dollar-cost averaging into an asset class.  For the true "buy and hold" investor, the market will eventually determine his allocation.

There are different ways of accomplishing this.  One approach suggests that we analyze our portfolios once a year at the start of the year and rebalance as we see the need at that time.  Another approach says that we rebalance whenever we see that we have drifted off of our target by a certain percentage, 5% for example.  Still others recommend rebalancing every six months.  Of course, the more often one rebalances, the more transactions cost may come into play.  Ideally, we should rebalance within a tax-sheltered account like a 401k or IRA as this will keep the tax consequences nil.

As long as one is contributing to a tax-sheltered account they can effect rebalancing by simply changing their future deferrals so that future contributions go into the asset class that needs to be increased.  Likewise, a retiree who is tapping their accounts can effect rebalancing by choosing to withdraw from the asset class that has gotten too big.  If they are having to take required minimum distributions they could obviously use these withdrawals to rebalance.

An article in a recent issue of the American Association of Independent Investors Journal illustrated the advantages of rebalancing over the past twenty years.  The author used a diversified portfolio of US and international stock and bond mutual funds for this study.  The portfolio was allocated 70% to stock funds and 30% to bond funds and was rebalanced once per year.  This portfolio was compared to one with the same initial allocation, but never rebalanced.   The portfolio that was rebalanced annually returned more over the twenty year period, but it averaged returning less than 1% more per year; however, the rebalanced portfolio was significantly less volatile over the time period.  Thus most investors would have found that holding the rebalanced portfolio less stressful during the swings in the market.  By committing to a strategy that forces one to rebalance their holdings we "sell when others are greedy, and buy when others are fearful."  That just happens to be how Warren Buffet explained his history of investing success.

Investing is a very emotional activity, and a number of studies have been devoted to examining the emotional aspect of investing.  Committing to the discipline of setting a target allocation and rebalancing at specified intervals has proven to take some of the emotion out of the process.  This is usually a good thing as there are those who became so emotional about the market decline of 2008-09 that they withdrew their funds from their equity investments at the bottom of the decline and have yet to reinvest in equities.  They have watched as the equity markets have nearly doubled since the market low of 2009.  A disciplined approach to their investment decisions, an approach that has proven its worth over time, would have helped them avoid such a costly decision.  Don't buy and hold; buy and re-balance.

Fly/Drive Safely

25 March 2012

The Andex Chart

Imagine that in 1926 your great grandfather, being a very farsighted man, put $10 in an investment of small cap US stocks, and left it there for you to grow with dividends and capital gains reinvested until January 2012.  How much will that investment be worth today?  That is just one of the many questions that can be answered by referencing the Andex chart put out and updated annually by the Morningstar, the financial services company that monitors and evaluates mutual funds.

The Andex Chart is a fascinating compendium of economic and historical data crammed onto one chart.  The current chart depicts the annual returns of various assets overlaying a timeline from 1926 through December, 2011.   Sprinkled on the chart are dots depicting various historical events that may have affected those returns.  Here a dot represents the fall of the Berlin Wall; there a dot represents the Challenger disaster.  On the far left of the chart we see the effects of the Great Depression; on the far right the effects of the Great Recession from which we are still reeling.

Along the very top of the chart in bar graph form one sees the yearly and decade-long returns of various asset classes.  One can quickly see that the ‘80s and’ 90s were great decades for equities; the ‘00s were not quite so kind.  Right below that are line depictions of the terms of the various presidents with other lines representing which party controlled the House and Senate.

The center of the chart is where the bulk of the data is depicted.  Seven squiggly lines, for seven different asset classes ranging from small cap stocks to 30 day Treasury bills, begin at the far left corner and extend up to the right showing how each investment has grown over the years.  Throughout this section is where the various historical events are pin-pointed.  There are heavy black lines representing America’s wars.  There is a dot for the attack on Pearl Harbor; another for Japan’s surrender.  Among many others there is a dot for the Bay of Pigs, the Cuban missile crisis, Neil Armstrong walking on the moon, Kennedy’s assassination, Nixon’s resignation, Microsoft going public, Russia’s debt default, 9/11, and Lehman Brothers collapse.  Through it all, with minor downturns here and there, the squiggly lines continue upward to the right.

Near the bottom of the chart the prime rate is graphed.  Notable there is the fact that it spiked as high as 21% during the early ‘80s when Chairman of the Federal Reserve Paul Volcker got quite serious about fighting inflation.  That is understandable for right below the prime rate graph is the graph of inflation which shows it peaked at just over 15% about the same time as the prime rate peaked.  According to the inflation graph it now takes $12 to buy what one dollar bought in 1926.  Today the prime rate is about 3.25%, near a historical low.  Along the inflation chart is a dot at 1938 representing the year the National Minimum Wage Act was passed which mandated that employers were to pay their employees the princely sum of 25 cents per hour.

The last graph at the bottom is a blue chart representing how the price to earnings ratio for the S&P 500 stocks has varied over time.  The median price to earnings ratio for that index since 1926 is 15.6.  The current ratio of 15.5, using the previous 12 months earnings, is right in line with the historical median.

So, what is the lesson of the Andex Chart? One is that our country has endured a lot since 1926.  We have seen three major wars that cost thousands of lives and shook us to our core.  There have been other dark days with two major shock events that killed thousands more (the attack on Pearl Harbor and 9/11).  Another is that there have been a number of major economic shocks that have rocked our markets and frightened investors.  But, through it all those squiggly little lines just keep on going upward to the right.  Of course there have been some periods where they declined for a while, but eventually they recover and head upward again.  In spite of all the challenges this country has faced, those patient investors who have remained in the equity market have eventually been rewarded.  I suppose the main lesson for me is that we should never sell our country and its economic prowess short.  I realize that we as a nation are facing a number of serious challenges currently, but I suspect they are no more serious than the ones previous generations faced.  They survived and prospered; I suspect we will as well and that those squiggly little lines will continue upward to the right.

You can easily find a sample of the Andex Chart online and draw your own conclusions.  Oh yeah, your great grandfather’s investment;  today it is worth $160,550!

Fly/Drive Safely

8 February, 2012