Rebalancing at Dawn
“The hour is darkest just before the dawn.“ Thomas Fuller
This is the kind of quote you’ll hear from seasoned investors in bear markets, after stocks drop in value for an extended period. And you’ll see them act on that optimism.
For example, about 5 months before the market turned around in 2009 Warren Buffet was touting similar catch phrases including, “When others are greedy, be fearful - When others are fearful, be greedy.” The Dow was about 8500 then and few were buying stock. He was 78.
Coincident to his statements he was converting his all bond portfolio to 100% stock. If we can agree that Buffet is a seasoned investor, then we would have to agree that most investors aren't seasoned. Or at least they don’t behave like they are.
The fact is, even though we know the market won’t go down forever, acting on this is counter-intuitive for most people. Likewise, when the market is soaring, it becomes harder and harder to resist.
The Investment Company Institute (ICI) is the national association of U.S. investment companies, including virtually every type of investment fund in existence. Members of ICI manage total assets of $16.5 trillion and serve more than 90 million shareholders.
Safe to say, it has mountains of data to track when and where investors are moving their money. ICI is constantly issuing data and reports. If you’re so inclined, you can find interesting research and statistics by clicking here.
Recently, the ICI announced that as of Q3 2013, Total U.S. retirement assets were almost $22 trillion. I’m emboldening this word because it has become somewhat commonplace; yet it is staggeringly difficult to comprehend a number that big.
It’s a number so vast, you’d have to count every second for the next 700,000 years to get in the ballpark of 22 trillion. If considering giving that a whirl, poking around on the ICI site linked above is a better use of your time.
Inside ICI’s Q3 2013 Retirement Market numbers, bonds found themselves “out of favor,” losing 1% for the previous year [as measured by the Aggregate Bond Index] as stocks [measured by the Standard & Poors 500] were up over 20%.
The money flow out of bonds and into stocks in the highlighted rows below are telling. You can decide for yourself if this is seasoned behavior:
If dollars were voters, 29 billion voted for stocks after experiencing double digit returns. 58 billion voters rejected bonds after a decline in value. Plainly put, they voted to buy high and sell low - the opposite of Mr. Buffet’s seasoned example above.
Another issue that arises when investors follow their gut is a systematic dissolution of portfolio diversification. That’s the fanciest way I can think of to say: they sell whatever isn’t doing well right now and buy way too much of whatever is doing better.
The trick to creating wealth over time is to remain invested in a variety of things that perform differently. And the trick to maximizing that experience is to rebalance the investments as values shift. The result is maintaining the approximate weightings you started with.
To illustrate what I mean, let’s create a person. That’s always fun. Meet Franklin McButterpants, who owned 50% equity (stock) funds and 50% bond funds in 2012. A year later, in 2013, Mr. McButterpants’ holds 60% stock funds and 40% bonds because stocks went up 20% and bonds were down a smidge.
Franklin, represented in the cash flow chart above, sold off bonds and bought more stock funds. He did this because, like most people, he prefers to make money rather than lose it. And stocks were the only things making money at the time.
In that light, it seems the right move. But sometimes, in the words of poet Robert Lowell, that light in the tunnel is an oncoming train. When we look at the math, even though Franklin’s investments had become riskier on their own (overweight in stock), he made them even more so. And he bought expensive stuff to do it.
This is why rebalancing a smartly diversified investment mix becomes so important.
A key issue, especially for retirees, is maintaining how risky the overall investment is. Stocks are riskier than bonds. So if we pile up on them we are piling on risk. Rebalancing minimizes risk fluctuation, but it also helps maximize our returns while doing so.
Ideally, McButterpants would have sold 10% of his stock funds to get back to a 50% overall allocation. He would use the proceeds to buy bonds back up from 40% to 50%. Risk exposure remains intact. Yay.
Further, Franklin would have done himself a huge favor because at some point, bonds will be the best performers again. And he just bought a bunch on the cheap. What a concept.
Proper diversification and adherence to a rebalancing strategy solves our natural inclination to chase performance. While rebalancing can’t prevent all investment risk or losses, it can help us take the statistically correct action when the hour may seem darkest.
Of course, this isn’t always the easiest decision to make. I mean…it’s dark. It’s hard to see when it’s dark. But then again, things are not always as they appear. Like selling stuff not doing well to buy stuff knocking it out of the park. If that still seems like a good idea, read this again.
I welcome your comments and questions,
Marc Becker, AIF
Managing Partner
Wiser Financial Coaching, LLC
