Assume you are making a long road trip with the speed limit a constant 55 miles per hour. Chances are you would see the speed limit sign and adjust your rather sluggish cruise control to 55 mph, sit back and enjoy your favorite music. Up ahead you see a steep hill approaching. Knowing that your speed may be reduced before the cruise control kicks in, you step on the gas pedal and accelerate, keeping a steady 55 miles per hour through the ascent. Once you reach the top of the hill you see a steep downward slope. Even with the cruise control, you know gravity will cause you to accelerate beyond the speed limit and possibly risk getting a speeding ticket, so you now downshift or apply the brakes. Strategic asset allocation is not much different.
Strategic asset allocation involves setting predetermined target allocations for various investments, and periodically rebalancing them back to their original allocation. When employing a strategic asset allocation, your investment choices are first selected to provide a risk-adjusted return over the time horizon of your client. Nothing remains the same and with time, the value of each portfolio allocation will change up or down depending on market performance. Like the road trip, you find that the entire road is not flat but full of peaks and valleys. This uneven fluctuation of the different portfolio asset classes causes the allocation to shift. As the portfolio was constructed to provide a specific strategy and allocation, you must rebalance the portfolio so it matches your original allocation.
When constructing a portfolio and choosing an asset allocation, several considerations must be taken into account. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets is appropriate is a very personal one and dictated by the client's objectives, time horizon, and risk tolerance. The asset allocation that works best for investors at any given point in their life will depend largely on their time horizon and their ability to tolerate risk. For many financial goals, investing in a mix of stocks, bonds, and cash can be a good strategy. Some investors may include other asset categories including real estate, precious metals and other commodities, and private equity. However, investments in these asset categories typically have significant category specific risks.
By including in a portfolio the three asset categories (stocks, bonds, and cash) an investor can minimize exposure to large losses because investment returns for stock, bonds and cash move up and down differently under varying market conditions. Historically, the returns of the three major asset categories have not moved up and down at the same time.
Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. The basic idea of diversification is that, by investing in more than one asset category, investors reduce the risk of losing money and their portfolio's overall investment returns will be more consistent. In other words, if one asset category's return falls, losses in that category are offset with better investment returns in another asset category. The objective is to try to pick the mix of assets that has the highest probability of meeting an investment goal at a tolerable level of risk.
Growth and Value
In my portfolio, I hold both growth and value ETFs. Portfolio management styles may generally be characterized as growth or value oriented. In a given economic environment, one style may outperform the other. Growth stocks are quality, successful companies who are expected to continue growing at an above-average rate relative to the market. They usually have high P/E (price-to-earnings) and P/B (price-to-book) ratios. Growth companies rarely pay dividends; investors are instead attracted to growth companies because of their potential for capital appreciation. While I would rarely purchase an individual stock that doesn't pay a dividend, I have no problem having a growth fund as part of my portfolio. My reason for this is because a fund is well-diversified among several growth companies, and I would rather see the companies reinvest their earnings back into the company, increasing their chances for growth.
Value stocks tend to have lower P/E and P/B ratios, and investors buy them because they hope the market will recognize their full potential (their “true value”) and boost share prices. The idea is that if they buy stocks at “cheap” prices and they increase in value, investors could potentially make more money than if they invested in more expensive stocks with a modest value increase.
A value stock is the proverbial diamond in the rough since a value stock's price probably won't reflect the company's fundamental worth. Value stocks almost always have good fundamentals; they're just out of favor with the market. When buying these stocks, investors should look for what's called a "margin of safety," which means that the market has discounted a stock more than it should have (the market has overreacted/acted irrationally) and that its current market value is less than its intrinsic value.
Sometimes growth stocks are perceived as too expensive and overvalued, pushing investors to value stocks. When this happens, my allocation shifts. The percentage amount in growth decreases and the percentage amount in value increases. Using strategic asset allocation, all I will have to do is move my money from value back into growth. I'll do the same thing throughout market cycles. Growth funds tend to better than the overall market when stock prices are rising, but they tend to underperform when the stock market falls. When this happens, it's easy to reallocate your portfolio to get the "growth" part of your portfolio back to its original allocation. This ensures that you will "buy low, sell high."
Because of my personal attitude towards investing, I am a big fan of blend funds, which exhibit the characteristics of both growth and value funds. Most managers of blend funds use a strategy called “Growth at a Reasonable Price”, or GARP. They look for growing companies, but at the same time remain conscious of traditional value indicators.
Take Advantage of Volatility
Please keep in mind that I am not telling you what to do in your personal life. I highly recommend you seek out professional advice before constructing your portfolio. Studies can be put together that demonstrate rebalancing growth and value will lead to a lower return, some of which are very true (especially if you take taxes and fees into account), but you must be cautious against those lying with statistics.
Investing is the ultimate exercise in patience since you must navigate through periods of short-term uncertainties. ANY approach can negatively impact performance, especially during bad times, making for a horrible investment experience. When you rebalance, you create the potential for additional return of lower volatility. Notice I said patience, not inattention. You need to pay attention to your portfolio so you can maintain the proper mix of investments through timely adjustments. Without attention, your portfolio becomes heavily weighted towards the well-performing asset, making you overexposed to more expensive (and riskier) assets and underexposed to cheap ones.
Another reason I'm such a big fan of strategic asset allocation and rebalancing is because it will minimize emotional involvement. Even the smartest people in the world will make emotional decisions when it comes to their investments. Such irrationality will come back to haunt you. The "herd" usually allocates capital to assets that have performed well in the hopes that it will continue its performance. They'll also sell when the markets have declined. This is "buying high and selling low" – the opposite of what you want. Emotional views of performance and attachment to certain investments are NOT logical, meaning they will harm your performance. Make it as easy as possible to minimize your emotional involvement. If you tell yourself that you will have a 35/35/30 split, rebalanced once per year, you give yourself no excuses to buy high and sell low. You will keep yourself from your own worst enemy.
Through rebalancing, you are harvesting the market’s volatility by taking advantage of mean reversion. If “what goes up, must come down”, why not have that work in your favor? All you’re doing is taking advantage of market volatility to benefit from the swings. You can either rebalance at particular points in time (quarterly, annually, etc.) or when investments pass your predetermined thresholds (when your allocation is off by a certain target, say, 5-10%). If you want, you can combine the two by choosing one or two dates per year to check your portfolio and if your target allocations are past your threshold, rebalance.
I know I keep stressing this, but please meet with your professional advisor to consider the right strategy for you. While rebalancing is a great move, it might create a tax burden if you sell your gains. In some instances, such as with taxable accounts, taxes could outweigh any benefits. You could always just put new cash into your accounts, but whenever possible, rebalance in tax-advantaged accounts like IRAs and 401(k)s. At the same time, don't let any tax argument hold you back from making decisions. I'm sure plenty of people held onto stocks in the 1990s just because they didn't want to pay the respective taxes. The market sure took care of that for them! Goodbye, gains!
Lowest Average Cost Wins
I’m a big believer in keeping cash on hand, and I believe you should do the same. Have a decent amount of money in a highly liquid “opportunity” fund so you can take advantage of market declines. Remember, the lowest average cost wins. Rebalancing is cool and all, but the real power comes from injecting cash during corrections and/or bear markets. You cannot average down if you don’t have an “opportunity fund” to strike when opportunities arise. These follow-up buys will lower your overall cost basis and have a powerful impact on your returns.
I like to ask people, “If you are in your formative investment years (just starting out), should you hope for higher or lower stock prices?” Most people wish for higher stock prices. They cling to some psychological justification that they’re making the right decision. Seeing the stock prices fall when they are investing makes them feel sick, stupid, incompetent, or all of the above. But this is silly! If you love to drink coffee every day (and you’re not selling it), do you want the price to go up or down? Investors love to see the price of their “coffee” go up, even though they know they’ll soon be buying it. The only reason you should want the price to go up is if you’re selling it in the near future. When you’re just starting to build your portfolio, you should never want high prices. Shift your mindset. Be joyous when the stock market drops, because it gives you an opportunity to stock up on your "coffee" before the price inevitably rises again. You know you're going to drink it every day, so you're going to buy it regardless of price, but when the price drops, you buy more! Likewise, if you sit on the sidelines and speculate that coffee will get even cheaper, you might miss out on a huge sale. People are so irrational when it comes to investing. Most people are sales-averse and wait until the stock market skyrockets to "stock up". You shouldn't necessarily be scared of a price drop. Understand that because owning a stock represents ownership in an actual company, a drop of 20% only makes sense if business earnings are expected to fall/have fallen 20%.
I should say that you need to be liquid in both cash and time. You need to have a “liquidity of time” because nobody is going to reach out to you and tell you where the opportunities are. You have to find them yourself. Take some time each day/week/month to look at your investments and the market in general. When an opportunity presents itself, you will catch it. Here’s a caveat: be careful when/if you average down on individual stocks, because you are prone to catching falling knives. You need to know what you’re doing and have a rock-solid valuation methodology. If you must average down on an individual stock, do it when nothing about a company has changed except its share price.
If you’re just a normal person socking money away for a comfortable retirement, don’t worry about averaging down on individual stocks. Focus on your mutual funds, index funds, and ETFs. You should be investing a certain amount at predetermined intervals, but if you see that your investment dropped 10% this month, put some extra money in. If it drops some more, take more money from your liquid account and transfer it to your investment. When you do this, you lower your average cost.
Let's say that you buy one share of an S&P ETF while it's trading at $100. There's a vicious bear market and the price declines to $50. If don't add any more money, your cost basis is $100 and your investment must gain 100% ($50) to get back to where you started. However, if you add another $100 after the drop, you now own three shares (your $100 bought two more shares) with $200 total out of pocket. This brings your cost basis down to $66.66 per share ($200 divided by three shares), which is a far cry from your original cost basis of $100! This also means that the stock only needs to increase a little more than 30% to match your cost basis.
Most people can’t do this because they don’t have the stomach for it. You should have total self-mastery and understand that you might not be able to touch the money for a long time. Novice investors see the big drops in their investments and get out at the worst possible time. Being a contrarian can come in handy because you'll be buying when everyone else is freaking out. By adding to an investment during drops and dips, you're just letting market volatility work in your favor to reduce your average cost.
When you do this, you won’t know whether your purchase price is near the bottom or if the price will go even lower. That’s why I say to keep a liquid account (which is different from your emergency fund!) that allows you to add on every drop. All you’re doing is reducing your average cost, which increases your return potential over time. There are no guarantees in the market, but if you can go against the grain and act consistently, you’ll undeniably tilt the odds in your favor.
Watch Your Taxes
This does not mean that I reallocate my portfolio every day, or even every month. I reallocate every year or so. The reason is that the government treats short-term and long-term capital gains differently. A short-term capital gain is any realized gain you get from the appreciation of your assets in less than one year. So if you buy a stock, watch it go up, and sell a month later, you'll get hit with the short-term capital gains tax. Short-term capital gains tax is the same as your ordinary income tax rate. If it happens to be as high as in the 30% range, you need to give this some serious thought! Long-term capital gains are better. Any gains realized after one year are taxed at a 15% rate. Lowering your tax burdens make a huge difference over an investment lifetime.
Taxes can pose a significant problem for investors, but too many people brush over them like they don't even matter. If they don't totally brush over taxes, they act like they're the Black Plague. What they don't realize is that taxes have been worse… much worse. At the time of this writing, the highest tax bracket in the United States is 39.6%, which is levied to those making over $413,200 on their own or $464,850 jointly. Just as an example, in the 1940s, tax rates were as high as 94%. That's right, you only got to keep six cents of every dollar, provided you earned over $200,000 (about $3 million today). President Franklin Roosevelt even told lawmakers that nobody should be taking home, after taxes, over $25,000 (about $335,000 adjusted for inflation). I don't know if your "number" is above $335,000 or not, but wouldn't you at least like to have the freedom to keep what you earn? If you're getting taxed out the wazoo, what will happen to your incentive to work?
Uh-oh, I’m getting off-topic here, going into a stream of consciousness… oh well. Let’s keep going. Here’s a little story about a young actor named Ronald Reagan. At the time when the federal income tax was over 90%, Ronnie was making about $400,000 per movie. Thus, he chose to loaf around rather than make more than two movies per year. Why should he have done a third picture, even if it was Gone With The Wind? What good would it have done him? Well, Ronald could’ve taken home a whopping six cents on the dollar!
By no means is this meant to be a political discussion, and I am not taking any political stances here. I just know that you while the rich shouldn't necessarily live tax-free, they shouldn't be taxed up the wazoo. With all this being said, I want you to take a good look at how your investments are structured in relation to taxes. Is there anything that you're putting in a taxable account that you could put in a tax-free account? You don't want to be a long-term investor and diligently invest for thirty years, only to find out that Uncle Sam has jacked up the tax rates. Right now, tax rates are low (historically speaking), so you should strongly consider getting into an account that cannot be taxed when you withdraw. I’m talking specifically about a Roth IRA. If you make more than $116,000 filing single or $183,000 filing jointly, you cannot contribute to a Roth, but if you make less, you can. The advantage of a Roth IRA is that you contribute your after-tax dollars. You see, Uncle Sam has to get his cut, and he’s either going to get it on the way in or the way out – it’s your choice.