A frequent complaint from some investors is that “uncertainty” is what keeps them out of the financial markets. “I’ll stay in cash until the direction becomes clearer,” they will say. So when has there ever been total clarity? Alternatively, people who are already in the market after a strong rally, as we have seen recently, nervously eye media commentary about possible pullbacks and say, “Maybe now is a good time to move to the sidelines.” While these kneejerk, emotion-driven swings in asset allocation based on market and media commentary are understandable, they are also unnecessary. Strategic rebalancing provides a solution, which we will explain in greater detail below.
But first, think back to March 2009. With equity markets deep into an 18-month bear phase, the financial media warned of more pain. Toxic assets still weighed on banks’ balance sheets, economic signals were patchy, short-covering was driving rallies, the Madoff scandal had knocked confidence, and fear was still widespread. Of course, with the benefit of hindsight, that month did mark the bottom of the bear market. In the intervening period of seven plus years, major equity indices have rebounded to new all-time highs. But keep in mind that these past seven years of recovery in equity markets have also been marked by periods of major uncertainty, with the most recent being the two-day drop after the Brexit vote.
In the financial media, there was a broad range of views about likely outcomes and how these possible scenarios might impact financial markets. The big question for the rest of us is what to do with all this commentary. The fact is, even the professionals struggle to consistently add value using analysis of macroeconomic events, as we see from the long-term track records of actively managed mutual funds vs. index returns. And history suggests that those looking for “certainty” around such events before investing could be setting themselves up for a long wait as there is always something to fret about. One does not have to look far to find well-reasoned discussion in support of why the market has topped out, alongside equally compelling reasons of why the rally might continue for some time. What is the average investor supposed to make of all this conjecture? One way is to debate the market implications of news and to try to anticipate what might happen next. But whom do you believe? We’ve seen there are always cogent-sounding arguments for multiple scenarios.
An alternative approach is much simpler and is one our core principles for successful long-term investing. It begins by accepting the market price as a fair reflection of the collective opinions of millions of market participants. So rather than betting against the market, you work with the market. That means building a diversified portfolio according to your own needs and risk appetite, not according to the opinions of media and market pundits about what will happen next month or next week. It also means staying disciplined within that chosen asset allocation and regularly rebalancing your portfolio. Under this approach, better-performing investments are typically sold after a significant run-up in the market and re-deployed into underperforming assets. The trigger for rebalancing is not media speculation but the need to retain your desired asset allocation.
Say you have chosen an allocation of 60% of your portfolio in stocks and 40% in bonds. A year goes by and your stock allocation has rallied strongly so that the balance between the two has shifted to 70%/30%. In this case, it makes absolute sense to take some money out of stocks and move it to bonds. It works the other way, too, so that if stocks have fallen in relation to bonds, you can take some money out of bonds and buy stocks. Essentially, this means buying low and selling high. But you are doing so based on your own needs, rather than on what the armies of pundits say will happen in the market next.
Of course, this doesn’t mean you can’t take an interest in global events. But it does spare you from basing your long-term investment strategy on the illusion that somewhere, at some time, “certainty” will return.