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MAKING CENTS OUT OF THE NEWS
Blog #11
(March 18th, 2010)
ASSET ALLOCATION AND REBALANCING - TRIED AND STILL TRUE
By Tom McAllister, CFP®
Back in the winter of 1962, at Merrill Lynch Training Class, what they taught us was - diversify, diversify, diversify. Down through the years, this emphasis proved a wise approach to passive investing for my clients. Later in my career, asset allocation became the favored term when referring to diversifying a portfolio.
Asset allocation is the division of an investor’s capital among the different asset classes available. Typically those include U.S. publicly traded stocks, foreign stocks, U.S. Government bonds, domestic and foreign publicly traded bonds, real estate, cash and cash equivalents (money market mutual funds), plus less traditional assets such as hedge funds and commodities (gold, silver, and precious gemstones).
The concept is simple: A widely diversified portfolio with an asset allocation approach is supposed to protect the investor. When prices plummet in one area, the effect is offset by stronger performance in other sectors. Many advisors carried this approach to the next step, assigning fixed percentages to each asset class based on each investor’s personal situation. In theory, for example, a client in retirement would not have as high a percentage of assets in equities, stocks, or real estate, while a younger investor making annual additions to the portfolio, would have a higher equity exposure. So far, so good. The next step of the process consisted of "rebalancing". This was a theory calling for, on a quarterly, semi-annual, or annual basis, restoring the portfolio to the mix originally assigned to the account.
The rebalancing technique never made sense to me. Selling at least part of the "winners" in an account and moving the money into that part of the portfolio that is not performing as well is not only counterintuitive, it may or may not work over the long term. In fact, on a quarterly basis, I've found, this approach leads directly to underperformance. Let me point out, on the other hand, that I have no problem with investing new monies, whether from dividends and interest or from new portfolio contributions, in what appear to be the most attractive opportunities available at the time.
The whole concept of diversification was called into question with the near-total breakdown of the U.S. financial system, along with sympathetic trouble in the economies of our other major trading partners around the world. Prices were lower in virtually every sector of passive investing. Stocks crashed, Real estate crashed to an even greater degree. Corporate and municipal bonds went begging for buyers. Even some money market funds had to break their $1 principal share price due to the turmoil in the markets. Some hedge funds did not suffer quite as badly as the overall markets, but many fared even worse, with quite a number quietly closing. up shop as lenders called in the loans they'd used to leverage their positions. The only assets to weather the storm were U.S. government bonds and pure cash.
The stock market has, of course, rebounded nicely in the last year. Real estate remains largely a disaster. Longer-maturity bonds look very risky because of the higher interest rates virtually all observers expect in the years ahead, while short-term bonds offer next-to-nothing yields! So how can asset allocation theories help us from here?
Diversification and asset allocation still make the most sense, particularly under the guidance of trained, professional money managers who can set emotion aside during troubled times and make rational (if not infallible) decision as to which asset choices and investment approaches apply.
As a professional money manager myself (at least I take responsibility for selecting money managers for my clients), I recognize the paragraph above can be thought of as self-serving.
At the same time, our track record since March of 2009 has been good indeed - we were fully invested when stocks hit bottom and our clients have reaped the rewards. Each investor's situation is unique, and a good advisor can help you arrive at a comfortable asset allocation in keeping with your own circumstances and risk tolerance.
Back in Merrill Lynch training class it was true, what they taught us about portfolio diversification to modify risk, and it's still the best and safest route for passive investing I know.
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