Saturday, September 20, 2008

Why The Down Market Is Good For Me

So.... the U.S. financial market is in the toilet, our free-market capital system is now looking a little bit Socialist and my tax bill will be huge soon. Last Wednesday, my 401k was down $14,000+. (Although it's back up slightly, I think this recent rally is a short-term, fake-out.)

There's no other way to say it - this really bites.

But since my retirement is 20-30 years away, I'm not (too) worried because there is still plenty of time: (1) to dollar-cost average, (2) for the market to rebound and (3) for my money to compound.

And beyond that, there is one reason why I think this volatile, down market is good for me: I can learn, while my money is less at risk, how to protect my assets proactively in a bear market when I'm closer to retirement.

It's The Allocation, Stupid
Whenever the stock market tanks, there is no shortage of articles telling people what stocks/funds to buy and what defensive moves should be taken. But by the time the market is in a downward trend, it's probably too late to move assets around without falling into the trap of "buy high, sell low."

With respect to retiring in the current bear market, Craig Carnick, who runs Carnick & Co. in Colorado Springs, Colo., recommends raising a buffer of cash ahead of time as the easiest way to keep a portfolio intact during uncertain times. In this article, Carnick says,
"The key to overcoming volatility is that you're not in a position where you're forced to sell at a loss." Carnick recommends keeping up to 20 percent of a portfolio in cash or cash equivalents, or enough for two to three years' worth of income, plus a mix of bonds with varying maturities set to expire over seven to eight years to replenish that money.
In the same article, Dean Barber, a financial planner and founder of Barber Financial Group, says allocating as much as 30 percent of a portfolio to treasury inflation-protected securities, or TIPS, isn't unreasonable, given shaky markets and rising price pressures.

Barber recommends filling out a portfolio with exposure to commodities, cash, and foreign stocks, adding that no more than 30 percent of any retirement portfolio should be in domestic stocks. A few years ago, the allocation would have been 60 percent. That's just too risky now, Barber says. "Retirement is not like golf. There are no mulligans. If you mess it up, you go back to work for 20 years. People can't afford to get it wrong," he says. "The portfolio we have today is more defensive."

Take Profits and Re-Allocate While You're Up
In January 12, 2008, I read this article about various index fund portfolios maintained by real people. One of the highlighted portfolio is managed by Ted Aronson of AJO Partners. In the article, Ted Aronson highlights the importance of taking profits off the table and reinvesting in laggard performing funds/stocks.

"The equity funds in [Aronson] family's taxable portfolio averaged a return of more than 21% the past five years, thanks to his high 40% in foreign funds: But 'I realize a change -- a big change for a lazy investor -- is needed. Time to take some profits off the table,' says Aronson.

'For a U.S.-based investor, 40% international is way too high at this juncture. With the dollar's weakness goosing up foreign returns, and emerging markets having gone almost straight up for five years, time to trim the tree.'

So Aronson is taking 10 whole percentage points "out of emerging markets and putting half into TIPs and half into high-yield bonds." His detailed reasons:

  • Everything has gone up double digits over the past five years -- except bonds

  • Emerging markets have gained 36% a year -- nearly a five-fold increase

  • Dollar is weak retrospectively

  • Moving money from emerging markets to junk bonds leaves plenty of capital at risk (how you make money)
  • So, since most portfolios are likely out of balance, Aronson recommends this key asset re-allocation: 'If an investor held anything like 20% in emerging markets five years ago and was 'lazy' in the interim, your holding is more like 40% of the portfolio by now! Moving it down to 10% (from an original 20%) will entail lots of gains. C'est la vie.' My translation: No one goes broke taking profits.).

    Now comes this year's big lesson: Aronson warns that most investors will psychologically resist selling the big winners and buying lesser performers. But that's what rebalancing and "Modern Portfolio Theory" (the theory behind Lazy Portfolios) is all about. You stick to your asset allocations as sector performance waxes and wanes over the long-term. Otherwise you're just chasing hot sectors and engaged in high-risk market-timing.

    Alternatively: If you're serious about your long-term results, instead of doing an end-of-year rebalancing, rebalance each month. But not by selling high performers, just add new money from your regular monthly savings program to keep your portfolio in line with the original allocations."
    At the time I read this article (January 2008), I recall thinking, "But, the emerging market fund is so 'hot'! I wouldn't do this!" Well..... since 12/31/07, the emerging market fund is down over 29% and the bond fund is down less than 5%. I guess this is why Aronson is the pro and I'm the amateur. He he.

    I always thought that following market movements and trends were important to establishing your own personal asset allocation. But the more I think about it, Aronson's recommendation is less about market timing and more about having an appropriate, diversified allocation and maintaining the allocation through market ups and downs. In other words, if my current allocations are completely out of alignment with my target allocations, that should be a hint for me to reallocate my assets.

    Therefore, as I get closer to retirement, I'll need to remember to take profits off of bloated asset categories while it's up and re-allocate to a more conservative portfolio which consists of higher allocation of cash, bonds and TIPS.