Why You Need to Rebalance



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Suppose you invested $100,000 on January 1st, 1995. You invested $50,000 in the Barclays U.S. Aggregate Bond Index and $50,000 in the S&P 500 (U.S. stocks). Between January 1st, 1995 and December 31st, 2002, you were in for quite a ride as the Dotcom Bubble expanded and eventually popped. Your bonds would have offered annual returns of 18.46%, 3.64%, 9.64%, 8.70%, -0.82%, 11.63%, 8.43%, and 10.26%. Your stocks would have offered annual returns of 37.58%, 22.96%, 33.36%, 28.58%, 21.04%, -9.11%, -11.89%, and -22.10%. Declining interest rates and the mania surrounding Internet-based companies fueled some really good returns during that period. In fact, if you didn’t touch your $100,000 portfolio at all during that period, I’d estimate you would have had around $206,000 by the end of 2002.

Do you notice how the last three years of S&P 500 returns from 2000 – 2002 were negative as the bubble popped and a recession began? Wouldn’t it have been nice to have liquidated your portfolio on December 31, 1999 and missed the stock market pullback? If you had, your portfolio would have been around $248,000 on December 31, 1999; $42,000 better than it would have been worth three years later!

By now I hope you know me well enough to know I’m not the type to ever advise you going all in or all out of the market. When it comes to market timing like that, I’m just not that smart, and I don’t think anyone else is, either. I believe in calculated tactical adjustments to a portfolio if you see a medium to long-term trend, but I do not believe in ultra-short-term trading and all-in / all-out investing. There's just too much uncertainty!

Some of you that were investing back in the late 1990s and early 2000s may be able to remember how hard it would have been to sell out of your high-flying stock portfolio on December 31, 1999. That was a time (like many times before) where the sky felt like the limit.

Great, Tom. You’ve told me this story about how I would have been better off selling my January 1st, 1995 portfolio on December 31st, 1999 versus holding it until December 31st, 2002, but then you told me no one can know exactly what the future holds and not to invest all-in or all-out. What can I do? You can rebalance.

Rebalancing your portfolio is something you should periodically do to bring your portfolio strategy back in line with your initial investment strategy. Sure, it can be a hassle, it can generate some capital gains taxes, and it can generate some trading fees, but oftentimes, it’s worth it. Hopping back to our 50% bonds and 50% stocks January 1st, 1995 portfolio example, did you know that by December 31st, 1999 your portfolio would have only had 29% bonds and would have swelled to 71% stocks? Would you be happy if the portfolio strategy you agreed to in 1995 drifted that much? I don’t know many investors who would be pleased with a divergence from their investment strategy of that magnitude. That’s why in the spirit of trying to more closely maintain your investment strategy and hedge your bets on the markets continuing to roar upward vs. correct downward, periodically rebalancing your portfolio is the way to go. Excluding taxes and fees, if you would have rebalanced your January 1st, 1995 portfolio at the end of every year back to a 50% bonds and 50% stocks portfolio, your portfolio would have had around $216,000 by then end of 2002; $10,000 better than if you had done nothing at all. Rebalancing your portfolio can generate taxes and transaction costs, but it also, and more importantly, allows you to not drift too far from your investment strategy. Rebalancing is a prudent way to hedge your bets on the market going up or down in the future.

I don’t often trade a portfolio, but when I do, I prefer to rebalance. Does that make me the most interesting wealth advisor in the world?

-Tom

You Might Be Well Diversified If...

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You are probably familiar with comedian Jeff Foxworthy’s “You Might Be a Redneck” routine. If you’re not, you should be! His routine is hilarious, and since I was born and raised in the Southeast, I've seen some of what he is talking about. I’ve seen driveways where it doesn’t look like the boat has left the driveway in 15 years. I’ve seen people whose dog and wallet were both on a chain. I’ve seen yards where if someone mowed them, I believe they might just find a car! It’s funnier when he does it, but you get the point. Either way, it got me thinking about an idea for today’s post…

By now you’ve probably gotten the year-end statements for most of your investment accounts, and if you’ve looked at them closely, you might have noticed 2014 was kind of a weird year for stocks. I say it was a weird year for stocks because some of the classes of stocks had very different returns. U.S. stocks ended up having a pretty good year after some ups and downs, but international stocks finished the year down for the most part. If you took a closer look at U.S. stocks, you likely found that the stocks of large U.S. companies (“large cap stocks”) did pretty well, but the stocks of smaller U.S. companies (“small cap stocks”) were not up nearly as much as their larger counterparts. Small cap stocks were even negative for a good portion of the year!

Statistically speaking, the S&P 500 (an index that represents large cap stocks) was up between 13% and 14% for 2014. The Russell 2000 (an index that represents small cap stocks) was up around 5% for 2014. The MSCI EAFE (an index that represents international stocks) was down around 5% for 2014. Why do I tell you all of this? To share with you that, if you had a stock portfolio filled with large cap stocks, small cap stocks, and international stocks, you probably didn’t end up with the 13% to 14% return “the market” had in 2014 that the television pundits, radio hosts, and investment newsletter writers keep talking about! As Jeff Foxworthy might say, you might be well diversified if you did not end up with the S&P 500’s return!

I’ve also heard it said that you know you are well diversified if there is always part of your portfolio that you are “mad” at. I’m not sure that’s always the case, but there is definitely some merit to that statement. If you were mad at your bonds in 2013 when the stock market roared, I bet you were pretty pleased with them in 2008 and 2009 when the stock market took a dive. If you were mad at your stocks in 2008 and 2009, I bet you have been pretty pleased with them the last five years or so. So all in all, you might just be well diversified if there’s usually a part of your portfolio that you aren’t pleased with.

If what I’ve said so far hasn’t really applied to you because you only own one stock or a couple of stocks, I’d offer two things. First, concentration in a single stock is how you can accumulate and/or evaporate wealth - not preserve wealth. Second, you might be well diversified if you can’t name every holding in your portfolio from memory!

As your friend and someone who wants you to do well and make as much money as you can, I wish you were completely invested in the S&P 500 last year and got that 13% to 14%. However (and please read my next words very carefully), as your humble financial blogger and a financial advisor who believes in the long-term investment strategies of diversification and compounding, I certainly hope you didn’t!

-Tom

Index Funds

Credit: Stuart Miles

An index fund is a mutual fund constructed to try to match or track the components of a market index, such as the Standard & Poor's 500 Index (S&P 500), Dow Jones Industrial Average (DJIA), NASDAQ, MSCI EAFE, or Barclay’s Capital Aggregate Bond Index. This type of fund is very attractive to many people I meet. “Indexing” is a passive management investment strategy and it has, at times, outperformed actively managed investment strategies. There are aspects of index funds that I like, and aspects that I do not. Playing devil’s advocate, let’s see whether index funds are for you.

Index funds provide a good way to make sure your assets are at least somewhat diversified, and with any luck, you should roughly experience gains (and losses) similar to those other investors and companies in the same indexes experience. Index fund investors usually believe that markets incorporate and reflect all information at all times, rendering specific “security picking” futile. Therefore, index fund proponents argue the best investing strategy is to simply invest in index funds. This passive strategy usually results in less buying and selling of positions (which means fewer transaction fees and potentially less-frequent, realized capital gains). Index funds also require fewer resources to oversee, which means they usually have pretty low investment management fees. Keeping up with a particular index, paying fewer transaction fees, potentially paying less in taxes (in amount and/or frequency), and having to pay less in investment management fees sounds pretty darn good, doesn’t it?

People who decide not to go with index funds or are against “indexing” may have a wide variety of reasons. At a very basic level, it could probably be said that people invested solely in index funds are just trying to “keep up with the Joneses.” They want to make the same investment return as their next door neighbors. This is not an acceptable investment strategy for many people. It’s true that if you don’t invest in index funds, you might generate returns less than the index (or even losses when the index has gains), but you could also beat the index and do better than the Joneses! In order to have this shot, you have to do something different than the index and pursue a more actively managed investment strategy. When proponents of passive index fund investments hear the words “active management,” they may quickly cite the lower fees and taxes usually associated with index funds, but active management supporters like to remind index fund investors that if they pay any fees or expenses at all and are only invested in the index, they are actually agreeing up-front to accept a return less than the index every single time!

Most investors seem to go back and forth on whether they like passively managed index funds or not. It seems that when most index funds have recently outperformed their actively managed, competitive funds, they have lots of fans, but when they lag active funds, their support seems to dissipate. I’m like everyone else: I’d love to have owned what has recently done the best and to currently own what is about to do the best, but as always, the super short-term investment crystal ball is in the shop!

What? Oh, you’re going to force me to choose? Look, I respect and understand people who swear by index funds, but I’m personally not a huge fan. I think having some index funds as part of your portfolio is certainly reasonable and it could even be a good idea, but I could not solely invest in them. I don’t want to keep up with the Joneses, I want to pass by the Joneses and move to another neighborhood! It comes down to two things for me: 1) I believe there is almost always a part of every index that I don’t want to invest in, and if I “index,” I can’t avoid that piece, and 2) as a very simple and not-so-technically-versed client of mine told me after we discussed index funds, “I prefer actively managed funds because I know there is at least someone at the wheel as opposed to my investments being on auto-pilot.”

-Tom

The Best Time to Invest

Credit: Stuart Miles

One of the most common questions I get in my line of work is something to the effect of “When should I begin investing?” or “When should I invest this particular portion of money?” Many brokers and financial advisors would talk to you about their ultra short-term market expectations or about trying to time the market (investing right before the market goes up a lot), but you won’t get any of that hypothetical schmoozing from me. A dictator’s unforeseen actions, a politician’s ill-conceived comment, or a shocking corporate scandal can throw even the best short-term market forecast out the window, so more often than not, I reply to someone asking me about the ideal time to invest with a very simple answer: “Probably now.”

“Now” is not a cop out. “Now” is not due to lack of knowledge or experience on my part. “Now” is not because the sooner you invest, the sooner I can talk with you about investment allocations and options. “Now” is about statistics, probability, and history. (Please click on the link and watch the video created by Time Magazine showing how $1 invested in the U.S. market has grown from 1927-2012 as well as what was in the headlines of Time.)

From a long-term investment return point of view, I think it’s safe to say that the last 85 years have been pretty awesome, but that’s not to say things haven’t been volatile. What if I told you that the S&P 500 has either been up more than 20% (which is a lot) or down (you lost money) for 18 of the last 32 calendar years, meaning returns have been between 0% and 19% (moderate growth) in only 14 of the last 32 calendar years? Well the market has been, so in order to be in a position to possibly enjoy some future, compounded long-term investment returns (like the ones you just saw if you're a good person and watched the video), I’d argue that you need to go ahead and pursue a prudently diversified long-term investment strategy and agree to stay on the market roller coaster. I just don’t think “guaranteed” annual returns of any substance are possible.

Another statistic worth mentioning is that, according to J.P. Morgan’s September 30, 2013 Guide to the Markets, the S&P 500 has had an average intra-calendar year drop of 14.7% every year since 1980. This means that the stock market has been down an average of 14.7% at some point during the calendar year despite its strong overall returns! I know of no other statistic that more clearly emphasizes the importance of a strong and patient stomach for market volatility. I also believe that in order for investors to have a stomach for market volatility, they need to have enough cash on hand, an understanding of their long-term financial strategy, and confidence in their financial advisor.

I’ve thrown a video and a couple of statistics at you that you may have found a little surprising and encouraging, but I’m not sure I’ve yet made a solid case for why investing now is likely your best course of action. You should consider investing now because over a long enough time frame the stock market has always gone up, and if you’re a betting person, the market has gone up more than it has gone down. Please understand that I am not saying you will have a better long-term investment return if you invest today versus tomorrow. What I am saying is the odds are in your favor!

If the current risk of market volatility is holding you back from investing, please know that there will always be market uncertainty no matter how long you wait to invest. There is a lot of recent and not-so-recent history to support investing now. In the battle of current market uncertainty versus market history, I personally choose history, but if you’re still not sold on this, I’d be happy to share some more of my thoughts with you and offer some techniques that can help you finally put some of your cash to work over time.

-Tom

DJIANASDAQS&P500MSCIEAFE

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You know all those acronyms you see scrolling across buildings in Times Square? What about those acronyms that just keep coming across the bottom line of your television on those financial channels like some sort of endless “follow the ball” sing-a-long? What are those things? Many people know that when the arrows are pointed up, the font is green, and the person ringing the bell at the end of the day is smiling that those acronyms have done well, and when the arrows are pointed down, the font is red, and the person ringing the bell at the end of the day is frowning that those acronyms haven’t done so hot. But really, what are those things? Let’s talk about some of those acronyms, what makes them different, and how I would propose you think about indices (the fancy plural of index) relative to your own investment accounts.

• DJIA - The Dow Jones Industrial Average (DJIA) is a popular U.S. market index that was created in 1896 by The Wall Street Journal editor, Charles Dow, and named after statistician, Edward Jones. The index is designed to gauge how 30 large, publicly owned companies based in the United States have fared during a trading session. The companies are primarily made up of industrial and consumer goods manufacturers, and the editors of The Wall Street Journal (who choose the companies that make up the DJIA) have historically chosen companies that have been around for a while, have a proven reputation, and will likely be around for a lot longer. Despite being made up of only 30 stocks, the DJIA is widely considered to be a useful market indicator in the U.S.
• NASDAQ - The National Association of Securities Dealers Automated Quotation (NASDAQ) was created in 1971 and was the world’s first electronic stock market. The NASDAQ is a computerized system that allows investors to trade more than 5,000 stocks, many of which are technology companies. While the DJIA is simply an index, the NASDAQ is an actual exchange like the New York Stock Exchange (NYSE) where buyers and sellers can trade securities. Although not always the case anymore, most NASDAQ stocks have ticker symbols (abbreviations representing a company) of four letters or more whereas most NYSE stocks have ticker symbols of three letters or fewer.
• S&P 500 - The Standard and Poor 500 (S&P 500) is a popular U.S. market index based on 500 large cap (large market capitalization) U.S. companies. A committee of analysts and economists selects the companies that become components of the S&P 500 based on size, liquidity, earnings, stock price, and industry. The S&P 500 was first published in 1957 and, because it includes more companies than the DJIA and is less skewed towards technology than the NASDAQ, many people regard the S&P 500 as the best representation of the overall U.S. market and U.S. economy.
• MSCI EAFE – The Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) is an international index that attempts to represent large and mid-cap companies across the developed world, excluding the United States and Canada. The index was created in 1969 by Morgan Stanley and is made up of more than 1,000 stocks in more than 20 countries. The MSCI EAFE is probably the most famous international market index in the world.

 

While I could go on and on about many of the other relevant and useful stock indices out there, I would like to also share with you a few thoughts on how I wish I could convince my friends, family members, and clients to view stock indices. You see, one of the many hats I wear as a financial planner is that of an investment advisor, meaning that many of the clients I serve have questions for me relative to their investment performance versus the performance of the indices they constantly hear about by newspaper, television, radio, and smartphone. It’s perfectly natural for someone to want to analyze their investment performance relative to a benchmark of some type, but it’s important to also realize an index is just an index. If you have a lot of cash or bonds in your portfolio and the DJIA has a huge rally, your overall return will probably lag the index because you’re not solely invested in 30 stocks. If the technology sector has a dot-com bubble burst and the rest of the market remains fairly flat, your diversified portfolio investment performance will probably outperform the NASDAQ because you are more diversified. If you’re all in on Greek shipping stocks, your performance probably won’t match the returns of the S&P 500 because it’s not even comparing companies based in the same country!

 

Your investment return versus the returns of indices is not apples to apples; it’s apples to oranges. If your investment return is substantially and repeatedly different than the direction of appropriately comparable indices, you may need a new investment strategy or maybe even a new investment advisor. If your investment return versus the returns of appropriately comparable indices are in the same direction, reasonably close, and you can understand how your allocation or risk tolerance is different than that of the index you are comparing your return to, then normally, I wouldn’t be too worried. Someone gloating over how their international small cap stocks outperformed the DJIA’s 30 U.S. large cap stocks makes no more sense to me than someone bemoaning that their conservatively balanced portfolio made up of cash, bonds, and diversified stocks underperformed the all-stocks S&P 500.

 

Indices are good points of reference and can be decent benchmarks, but so are exit signs on the interstate. I hope the next time you see something that resembles DJIANASDAQS&P500MSCIEAFE-like gibberish you will remember a few things from this post about what a few, common indices represent, and will think of them as relative - not absolute - performance benchmarks to your own investment portfolio.

 

-Tom