(Posted in Money Mondays)
This is the final part of my three-part series on how I invest my nest egg. First I talked about decreasing your risk with diversification across asset classes. Then I discussed matching your risk tolerance to your own allocation among asset classes. But this is where the magic happens.
Part Three: Periodic Rebalancing
You've probably read the stats that a surprisingly small number of trading days determine a large percentage of the stock market's gains. From 1963 to 2004, 1% of the trading days accounted for 96% of the market's gains. In the period from 1990 to 2005, a buy-and-hold investor would have realized average annual returns of 11.5%. Contrast that with someone that was going in and out of the market during that 15-year stretch and managed to miss the 10 best trading days of that period. He would have realized only an 8.1% return. Now it's true that if he had managed instead to miss the 10 worst trading days, he would have realized a 15.3% return, but it turns out that people are notoriously bad at getting in before the gettin' is good and getting out before the market tanks.
While the market has doubled since the bleakest days of 2008, mutual fund outflows were at record highs during that same period. Investors pulled nearly $260 billion out of U.S. equity funds since then, missing an awful lot of upside. The percentage of households that hold stock has fallen each year since the financial crisis hit, to a new low of 46.4% in 2011. Unfortunately, investors tend to sell as the market is tanking and buy as it is rising. That's why over the two decades ending in 2010, investors' average annual equity returns were 3.8%, even while the S&P 500 returned an average of 9.1%.
There's a perfectly good explanation for this: People are human.
So what to do about this predicament? Remove the emotion.
Once you have determined what your ideal asset allocation is, you have to do a little work to keep it there. Let's say your risk profile provides for a 50/50 split between stocks and bonds. Let's say it's 2009 when the stock market returned 26% and the bond market returned 11%. At the end of 2009, your 50/50 allocation is out of whack. At that point, you would hold 53% stocks and 47% bonds. Rebalancing just means you sell some stock to get back down to 50% and move the difference into bonds, getting you back to your target asset allocation. Conversely, at the end of 2008, after stocks went down 37% and bonds went up 20%, you'd have a 34/66 allocation of stocks to bonds. In which case, you'd sell some bonds and move that money to stocks.
In both of these cases it wouldn't feel very good to do, abandoning some stocks after an upswing, or dumping money into stocks after the've just tanked. But it would force you to buy low and sell high on that portion of your portfolio that needed rejiggering. That's rebalancing.
Now, if you decide that the eurozone turmoil, or the Fed's quantitative easing, or potential election results mean that stocks are going to tank, and you decrease your stock allocation down to 20%, that is not rebalancing. That's market timing. You feel that it's a bad time to be in the market, and you are making judgment based on what you think is going to happen to that market. That's fine, it's not for me, but it may be for you. In any case, it's not rebalancing.
When I retired, I had 30% allocated to fixed income and 70% to stocks. As I mentioned before, I found that allocation to be a little aggressive for my risk tolerance. I will be shifting my allocation to a 40/60 split to more accurately reflect my risk tolerance. As I get older I expect to shift that even more in favor of bonds. That is not rebalancing, that is adjusting my asset allocation.
But rebalancing, that prevents me from moving with the pack. Which is good when the pack doesn't seem to be making very good decisions.
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