One of my favorite parts of the movie “My Big Fat Greek Wedding” is the liberal use of Windex as an antiseptic, pain killer and all-around cure-all. I think it was so funny because its use seemed so far out of my cultural experience, yet was very cute and at some level actually made sense (it contains isopropyl alcohol, after all).
Sometimes I get the feeling that many individual investors approach the investment process with a mélange of clichés, old wives’ tales, fables, and home remedies.
Here are some classic examples: “Sell in May and go away.” “Cut your losses, but let your winners run.” “Real estate is always a good investment – after all they aren’t making any more of it.” “Things will never be the same again (heard personally by me in 1987, 1991, 1999, 2001, 2008, etc.)” “This time is different” (heard nearly every time it’s not different). “Sell to the greedy, buy from the fearful.” “Buy on the rumor, sell on the fact.”
There are many, many more, but we hear these kinds of statements from the market commentators out there on a regular basis. In a certain context, each of them makes sense and might actually be helpful, but taken together they form a messy mingle-mangle – clearly not appetizing and potentially hazardous to one’s health.
First of all, it’s important to understand that there are many different types of investors, all of whom have different objectives, styles, tools, and language. Traders, who care about short-term movements in asset prices, will rely heavily on technical indicators, charts and the day-to-day news flows. “Cut your losses and let your winners run” makes a lot of sense for these kinds of investors.
For the “average” individual investor, who may be saving for long-term needs such as retirement, the strategies will be very different than for a short-term trader. A short-term trader’s “neutral state” may be 100% cash. The trader may only invest when the opportunity arises. Longer-term investors may hold no or only a little cash, expecting the greatest bulk of their returns to come from the big, broad movement of asset prices, not the daily fluctuations.
The second key element to understanding all this is asset allocation. Studies have shown that equities provide the highest return of all asset classes over the long run. Yet, investors with income needs or who simply feel worried about the volatility inherent in stocks will allocate some portion of their portfolio to bonds and/or cash. I personally approach asset allocation of as a measure of risk tolerance and not as a forecast on which asset class will perform better over some short period of time. Changes in circumstances, age, family size, etc. may lead to changes in asset allocation, but how we feel about the markets may not be a great reason to change one’s asset mix.
At any point in time, we all have an impression or feeling about how things are going in the economy, in the markets, etc. Usually the tone of these impressions is strongly colored by the direction of the stock market. When the market is declining, we tend to be less optimistic about its prospects. As it rises the opposite occurs. By simply giving in to these impressions, we could easily sell stocks (or fail to buy them) when we should buy them and conversely, buy them at high levels. This tendency is why most do-it-yourself individual investors tend to “buy high” and “sell low,” and hence, underperform the market. We all may feel pretty good about the stock market these days, but the “best” time to have added to stock exposure would have been in the August to October period when the market had dramatically declined and we were in the midst of what was feared could be a major meltdown in Europe. To the average person, buying more stocks at this time would have been very difficult. Yet, it would have been the “right” thing to do.
This is where a disciplined asset allocation and rebalancing strategy can help. Let’s assume we had a 50/50 stock/bond portfolio at the beginning of 2011.
For the year, doing nothing, this portfolio would have returned about 4.5% total return (these returns are index returns – your millage may differ). Simply by rebalancing twice during the year – once in the April-May period and once again in the August-October period – one could have increased total return by as much as 270 basis points to around 7.2% for the year.
This increased performance does not assume perfect market timing or foreknowledge of what the market was going to do. That is the beauty of portfolio rebalancing. At its best it can add to total returns with little effort. At a minimum, rebalancing encourages one to “buy low and sell high,” one of the investment clichés I really do like.