If the performance of your investments over the past year matches, or is worse than what’s happened to the stock markets indexes, you may be ready to throw in the towel and put what’s left into CDs. Many of the major indexes such as the S&P 500 have regressed to levels not seen in years.
The total return of the S&P 500 over the past 10 years is less than one-half percent. If you put $100,000 in an S&P 500 index fund in 1998, and just looked at the account today for the first time, you’d probably have a loss when fees are considered. Ironically, you would have done better investing the $100,000 in a one-year CD and rolling it over each year. Heck, a three-month Treasury probably could have won.
But the reality is that during that 10-year period you would have had some very large gains that could have been harvested for reinvestment or provided cash for vacations, home improvements and the like. Minimizing losses during bear markets can be very difficult and making up losses is often excruciatingly slow.
The need to rebalance
“What keeps you from having 10-year returns that look like that is a broadly diversified portfolio,” says William Suplee, Certified Financial Planner and president of Structured Asset Management in Paoli, Pa.
“When the markets are really rolling like 2003 and 2004, you’re actually selling some of your equity and capturing profits. But you have to rebalance; you can’t put it on autopilot.
“The downside of this is the people who are moving into CDs are getting crushed. What happens if the government prints a lot of money to pay for all its spending? The $800 billion bailout or the next trillion in stimulus has to get paid from somewhere. If they print that money it will be inflationary.”
Adding asset classes
Constructing a portfolio is a tough enough task for the pros, much less the do-it-yourself crowd. If you simply piece together a portfolio of individual stock market indexes you won’t necessarily be doing yourself any favors, says Jason Flurry, CFP and president of Legacy Partners Financial Group in Woodstock, Ga.
“The S&P 500 is not an efficient method of investing because it lacks a lot of things. The way you create efficient portfolios is by using multiple asset classes. If you have one thing it will produce a risk and a return. If you take stocks by themselves there will be a certain risk and return. If you add some bonds you’ll get a different return because bonds are usually less risky than stocks. If you add a third asset class you should have another return. As you add more asset classes in the right way — you understand the relationship of how one interferes with the other and how they react with their correlations — then you can produce more efficient portfolios that not only give you diversification but they give you allocation, and that gives you the types of returns you’re looking for.”
Here are examples Flurry provided of how certain portfolios would have performed during three particular periods: March 2000 – March 2003, November 1998 – October 2008, and November 2007 – October 2008. The examples provided for the three LPFG portfolios are not the exact mix that his company uses. Flurry created them to show that by adding multiple asset classes you can enhance return and reduce risk.
How to diversify
Flurry defines a diversified portfolio as one-third US S&P 500, one-third in an overseas index and one-third in a bond fund. Balanced is an even split among the S&P 500, overseas index, a bond fund and a short-term Treasury security. Allocated involves tweaking that mix a bit and adding a little more to one category and a little less in another.
The purpose of this isn’t to tout one particular financial planner but rather to show, among other things, the importance of determining the right mix and rebalancing as needed. Flurry’s results have come from years of education and experimentation. It’s not easy, which is why so many do-it-yourselfers rely on the typical “style” boxes — large cap, small cap, value, growth, etc.
“When you’re dealing with the three factors — how much market exposure you have — stocks versus bonds, how many small companies versus big companies, how much growth versus value as far as the way the portfolio tilts, then you don’t necessarily live in those tic-tac-toe boxes,” Flurry says.
“We don’t care so much about midcap blend and small cap value. It’s how much stock do we have versus bonds and then within that stock portion how much is large and small and how much is growth and value. I can’t control the market but I can control how much risk exposure we take. If we keep that consistent we can back into an expected reasonable rate of return.”
Taking out the dogs
Rebalancing a portfolio involves selling winners, or at least taking partial profits, and figuring out what to do with the dogs in your portfolio. Profit-taking helps reduce risk and it’s surprisingly difficult.
“For some reason the profit-taking discipline has been ignored even by experts. It’s a lot easier to just buy and hold and say I bought a good company and I’m going to ride it through thick and thin,” says Alan Lancz, president of Alan B. Lancz & Associates and LanczGlobal LLC in Toledo, Ohio.
“The main complaint of new clients about their previous financial planner or broker is that they felt no one was really watching their portfolio. They’d be good at buying but there would be no real strategy to get out. Many times they rode specific investments up, the market would correct and they’d ride it back down. It’s one of the most frustrating investment experiences you can have. It might even be more stressful than losing it from the beginning because when you have tremendous gains and you watch them wither away it’s really difficult to take.”
Lancz says he learned early on about the discipline of setting up target price ranges so you have an idea of when to get out of an investment. As a stock price is rising it’s easy to let greed rule your decisions. The stock price falls and you let yourself think it’s a great investment the drop is temporary. Next thing you know the stock has lost serious ground. Lancz stresses the importance of protecting yourself on the downside, as well when a stock tanks shortly after you buy it.
“We don’t usually get involved in an investment unless we see three to four times the reward potential as the risk. So, if we’re buying something at $20 and we think it’s worth $35 we want to make sure that we don’t see it going lower than $15 or $16. We’re taking a 20 percent or 25 percent potential risk for the potential of making three to four times that on the upside.”
There are many who will argue that the “buy and hold” philosophy of investing is dead thanks to market manipulation, day traders, hedge funds, and the like. You don’t have to throw in the towel but you do need to be proactive and set aside time to monitor your investments. If you decide to hire a financial adviser be sure that he or she has a plan to protect your portfolio.