If you didn’t have a chance to read last week’s post about Principles of Investing, I encourage you to read it before reading this one. The topics covered last week are arguably the first things you should be aware of before you start investing.
Today will be a continuation of investing principles. We will pick up where we left off last week and discuss rebalancing portfolios, active vs. passive investing, and timing the market.
Rebalancing Investment Portfolios
The first step once you deposit money into an investment account is to actually invest the money. Many people make the mistake of leaving the money in cash, so don’t be one of those people (unless you are intentionally keeping it in cash within the account). When you invest the money, you should be investing in a diversified portfolio that is allocated appropriately for your goals, time horizon, and risk comfort level.
I won’t get into fine details of portfolio construction today, because everybody has a unique set of variables and may require a different portfolio from their neighbor. You can find plenty of basic recommended portfolio allocations online. Or you can schedule a meeting with an advisor at Finity Group and they will help you customize an investment portfolio to fit your needs. 😊
A well-diversified portfolio will have a mix of US stocks, international stocks (from developed and emerging countries), big companies, small companies, growth stocks, value stocks, bonds, and possibly alternative assets such as precious metals, commodities, and real estate. The exact percentage allocated to each category will be dependent on the individual circumstances and goals.
If you recall the asset class diversification section from last week, you may remember the Callan Periodic Table of Investment returns. That was the colorful chart that illustrated how predicting investment returns from year to year is a real crapshoot, so it helps to be diversified. There is no way of telling which asset class will perform better or worse than others from one year to the next.
Hypothetically, let’s say you have a very basic portfolio of 50% US stocks and 50% international stocks. That is your target allocation, meaning you aim to keep a 50/50 mix between the two. Well, some years US stocks will do better than international stocks. Other years, international stocks will do better than US stocks.
We’ll pretend that US stocks outperform international stocks over the next year and as a result, a year from now your portfolio has 60% of the total balance in US stocks and 40% in international stocks. If you rebalance the portfolio back to your 50/50 target allocation, you will sell off some of the US stocks and purchase international stocks to get back to the 50/50 mix.
By rebalancing your portfolio as things get skewed, it forces you to sell some assets that have done well and reinvest in areas that haven’t done as well. Sell high, buy low. Buy low, sell high. Rinse and repeat.
Easier Said Than Done
As an investor, this can feel counterintuitive in the moment. You’re telling me that you want me to sell my stocks and mutual funds that are doing well and buy more of the ones that have underperformed?!?!
Yes, that is exactly what I am telling you to do. Remember, past performance is no predictor of future performance. Just because something has done well recently doesn’t mean it will continue to do well.
The investing world seems to be the only place where people prefer to overpay for things and avoid purchasing things that go on sale. People also often prefer to sell items at a discount after their perceived value has diminished in order to buy more of the overpriced items. It’s really quite illogical when you think about it.
If the local gas station raised prices to six dollars per gallon, would you become eager to purchase more gas for your car? Are you going to buy plastic barrels to store gas in so you can stock up?
If someone is willing to pay $6 for a gallon of gas, you will more likely take the gas out of your car and sell it to someone else, then start biking to work.
On the flip side, if gas prices miraculously drop to one dollar per gallon, are you going to stop driving and start riding your bike? Not sure what is going on here, but I do not want to purchase that inexpensive gasoline. It must be bad for my car if it’s so cheap.
All of you electric car drivers may not have been able to relate to that example, so let me try another one.
When the grocery store is having a sale on your favorite item, aren’t you going to purchase a few extra ones? Maybe you’re a millennial like myself and a big fan of avocados. Well, when large avocados are on sale at the grocery store for $1 each, you’re loading up your shopping cart. However, when the price of avocados is $4 each, you probably aren’t buying any unless you’re pregnant and have a major craving for guacamole.
When it comes to investments, treat your investments like other things you purchase in life. When there is a sale, time to buy. When there is a high demand for something, maybe hold off on buying it until prices are more attractive.
Other Benefits of Rebalancing
Not only does rebalancing help force you to buy low and sell high, but it also helps prevent your portfolio from getting too concentrated in any one sector. Using the previous example of the 50% US stock, 50% international stock portfolio, if US stocks have a multi-year run and international stocks decline for several years in a row, you could find yourself with a portfolio of 80% US stocks and 20% international. If the tables turn and US stocks take a dive and international stocks go on a run, you now have 80% of your portfolio tanking and only 20% of the portfolio doing well.
Rebalancing helps keep things balanced so your portfolio never gets too overweight in one sector and ensures you will always have some exposure in the areas that do well and won’t be overexposed to the areas that do poorly.
Passive vs. Active Investing
I wrote a post about active versus passive investments last year. Click the link in the previous sentence to check it out for a more in-depth view on the subject.
I am of the mindset that investor behavior has far more to do with outcomes and returns than the particular investment you select. It doesn’t matter if you invest in an actively managed fund or a less expensive passively managed index fund. If you succumb to emotion and sell when your investments are down (or haven’t performed as well as your friend’s investments) and buy after you see a particular investment have a good run, your returns are going to stink!
Like we discussed in the rebalancing section, the goal is to buy low and sell high. The only way to do that is to purchase assets after they have declined in value, or lagged other assets, and then to sell after they have appreciated in price. If you buy a position after you have seen a track record of positive growth and sell the ones in your portfolio that have underperformed, you will be faced with an uphill battle to achieve your financial goals. Buying high and selling low is not likely to produce good results.
Actively investing your portfolio, by moving things around based on your intuition or something you saw on the news, is a recipe for disaster for the average retail investor.
Passively investing in a portfolio by buying and holding for the long run and only rebalancing when your target allocation gets out of whack will likely deliver you much better results.
In my opinion, it doesn’t matter if you invest in actively managed mutual funds or passively managed funds. I couldn’t care less if you have a preference for one over the other. Go with what you like. What is most important is how you decide when to buy and sell and whether or not you stick with your initial investment strategy. Sticking with a passive investment strategy with the occasional portfolio rebalance is far more important than choosing an active or passively managed mutual fund.
Timing the Market
Dalbar Inc., does a study on this every year and they find that investor returns are considerably lower than the returns of the actual investments that the investors are investing in. By tracking when money goes in and out of mutual funds, Dalbar can tell that investors put money into funds that have seen positive returns as of late and pull money out of funds that have struggled recently. This leads investors to realize returns for themselves that are far lower than the average mutual fund return. They have concluded that if investors just parked their money and let it ride for a long time, they would do a lot better than they would by trying to time their investments move money in and out based on recent events.
This study further emphasizes my point about the irrelevance of picking the perfect mutual fund(s) for your portfolio. You could construct the perfect portfolio for your financial goals, but it won’t matter if you ditch it after the first sign of distress.
Trying to time when to get into an investment and when to get out is nearly impossible – especially for those of you reading this blog. I’m sorry, but it’s just not your area of expertise. It’s not mine either. Maybe if you are a CFA at a multi-billion dollar investment company, with access to research and tools that the rest of us don’t have, and you spend 12 hours a day scouring through financial data, then maybe you have a chance at timing things correctly over 50% of the time. For the rest of you, you’re better off flipping a coin to decide when to buy and when to sell.
Or better yet, just buy and hold! Then you don’t have to worry about figuring out when to sell. Makes things easier for you.
The greatest investor of all time, Warren Buffett, doesn’t even time the market. He is quoted for saying his favorite holding period is forever. His investment strategy is centered on purchasing quality companies for fair prices. He refuses to overpay for an investment. If he has an opportunity to underpay, he is like a kid in a candy store.
The results speak for themselves. By not overpaying for anything and holding onto his positions for the long run, he has turned a small little investment portfolio into a $500 billion portfolio over the last 60 years.
So turn off the news. Stop reading about current events. We have been through wars, terrorist attacks, presidential impeachments, economic depressions, mass health scares, and much more. For a long-term investor, the headlines today will have minimal impact on the long-term results of your investments. 30 years from now you won’t even remember most of what is happening in the world currently.
Most of us can’t even remember what was going on last week. Remember how we were all going to die of Ebola a few of years ago? Oh yeah…forgot about that. That was in the late summer/early fall of 2014. The virus made it to America by early October. The stock market (measured by the S&P 500) dropped by about 8% from mid-September to mid-October. Then we didn’t all die of Ebola and the market has grown by 56% since then (as of Friday 9/14/2018).
Diversify your investments. Spread the risk around different areas, so you aren’t overexposed to any one position or asset class. Have different accounts that are treated differently from a tax standpoint, so you can be prepared for changing tax scenarios over time. Invest your short-term money conservatively and your long-term money more aggressively. Stick with your investment strategy over time and rebalance your portfolio as needed to keep things in line. Don’t worry about current events, they probably won’t affect your long-term investments much at all.
This concludes the investing principles sections of Financial Planning 101. Tune in next week for a look at home buying.
Any investment involves risk and potential losses, including total loss of principal. Consult with your financial advisor before implementing any investment strategy.