By Carrie L. Coghill, CFP
I have been amazed by how investors who call themselves “long-term” have reacted to the market fluctuation, over the past three years. As an investment advisor, I’ve always preached my approach to the markets, which is based on asset allocation models that are designed to provide results over reasonable periods of time. This is very different than the market timer, who is trying to identify the short-term direction of the stock market and make decisions accordingly. Yet, many so-called “long-term” investors feel defeated by this past bear market. This type of reaction sends the message that investor education is needed, in order to prevent investors from throwing in the towel at the wrong time. Bear markets should not leave you feeling defeated. Not if you understand that they are a normal part of the economic cycle and not if you understand the true principles of asset allocation.
Asset Allocation is based on “Modern Portfolio Theory.” In 1952, Harry Markowitz, regarded as the “father of modern portfolio theory,” developed the first mathematical model that illustrated how risk can be reduced through diversification of investments that have different patterns of return. This concept had such a profound impact on the study of economics and investment management, that he was awarded a Nobel Prize for Economics in 1990. With such credibility and historical track record, why is it that investors have such a difficult time implementing this strategy?
The most prevalent problem with asset allocation is that investors don’t realize the basic principle of this model. The core of modern portfolio theory is that the focus should be on the overall portfolio, the bottom line. A portfolio should be designed of investments that work together to provide a smoothing out of portfolio fluctuation. Asset allocation shifts the focus from the performance of the individual securities to the portfolio as a whole.
At the risk of using the most basic of all analogies, I’ll do it anyway. Asset allocation is very much like baking a cake. The individual ingredients are not something you would consider sitting down and having as a meal: flour, raw eggs, baking soda, etc. But, when combined, the results can be incredible. For as minor as this may sound, the problem is that we, as investors, have been conditioned to look at our performance results on an individual basis, not on the portfolio as a whole. Just like with the cake analogy, if you leave those raw eggs out, your cake will be spoiled. You can’t eliminate one investment or sector of the market because it hasn’t performed well or is out of favor. If you do, you have now redefined yourself as a market timer, not an asset allocator.
With focus on your portfolio as a whole, and your individual investment selection designed to be distinctly different from one another, it becomes easier to see why asset allocation is a long-term strategy. Your individual investments will respond at different times, dependent on the many factors related to the economic cycle. Knowing that these patterns are cyclical, you must give your portfolio the necessary time to participate in these various cycles. This is another basic principle of modern portfolio theory. As your individual securities participate during their upside cycles, you will be rewarded for holding them when they were out of favor. In addition, because different sectors of the market experience their upside cycles at different times, your downside volatility will be dramatically reduced. Therefore, if you get out of a specific sector because it hasn’t performed, you will be dramatically increasing your risk and possibly eliminate your chances for return.
As a matter of fact, asset allocation encourages adding, or re-balancing, into the sectors that are out of favor. This promotes the basic idea of buying low. If you were to re-balance your existing portfolio, you would be taking some of the gains from the sectors that have done well and allocated into the sectors that are under performing. This promotes the basic principle of selling high. “Sell High/Buy Low” – isn’t that something we all want to accomplish? Then why is it so hard? The answer is easy: emotion. Think about it. Take from the investments that are making you money and reinvest into the investments that are losing money. Emotionally, it doesn’t make sense. That is why investor education is critical. If you develop the confidence that your investments really do perform in a cyclical manner and accept the fact that you will not be able to time these various cycles, you will have found the key to successful investing.
Unfortunately, you are not going to get much emotional support from the media if you are implementing an asset allocation approach. The information about the markets as reported by journalists is designed to get your attention, not necessarily to manage your money. If there is one lesson that should have been learned from the Internet bubble of the late 1990s, it should be: don’t let journalists manage your money! In addition, you should always ask yourself the question: where is this information coming from and does the source have an axe to grind? Has the source given good advice in the past? We’ve just been through a challenging time in the investment markets, from being at the top of the world to down in the pits. What were these gurus advising during this time? It’s amazing to me that we continue to take advice from the same people that were promoting a 30,000 Dow.
Another frustrating element to asset allocation is that there are no formal benchmarks to assist in the analysis of your portfolio. The performance of your portfolio is not going to be in sync with any of the major market indices. The Dow Jones Industrial Average, the most publicized of all benchmarks, is basically meaningless to an asset allocator. Remember, the Dow is made up of only 30 U.S. companies. That doesn’t do much for a portfolio that owns investments overseas and other asset classes such as real estate.
Many times, especially in times of extreme euphoria, such as the late 1990s, you may become extremely frustrated due to perceived under-performance of your portfolio, when compared to some of these well-publicized benchmarks. To overcome this, we must go back to the very basic question of financial planning: What are your goals? If you know that a six percent return will enable you to accomplish all of your financial goals and provide the resources to allow you to maintain your desired standard of living throughout retirement, then that should be your benchmark. Who cares how the Dow performs? Investing is about you and your specific goals. Not the goals of 30 companies, a journalist, or a stock analyst. I’m now in my 17th year of my financial planning career. Never has a client said to me “my goal is to beat the Dow!”
Carrie L. Coghill, CFP, is president of the Pittsburgh firm of D.B. Root & Company Financial Planning.