One is limited by fear and the other is at risk from greed – the two nemeses of successful investing. Both types of investors make mistakes that severely limit their wealth accumulation by limiting their compounded returns.
During bull stock markets, it’s not unusual for some clients to tell me they’re afraid of investing more money in the stock market at prices that they believe are at an all-time high. Those who had this concern two years ago have since watched the market post many subsequent all-time highs.
The folly of both groups lies in their denial of the reality that eventually, everything will go down. That’s right: All types of investments will eventually decline significantly in value — and eventually rise again. History shows that this has always happened, and it will continue to happen with the same certainty that the swallows will return to San Juan Capistrano.
Hyman Minsky, an economist and professor at Washington University, did research that shed light on economic factors indicating why. In his 1976 paper titled “A Theory of Systemic Fragility,” Minsky demonstrated how a stable economy always leads to optimism, to the point where people take more risks, which leads to instability because “success breeds a disregard for the possibility of failure.” He showed how “the absence of serious financial difficulties over a substantial period” results in a “euphoric economy” — where risk-taking gets out of hand.
Caught up in this optimism, banks lend to borrowers who aren’t likely to repay the loans. This and other factors transform a healthy economy into a debt-ridden one, resulting in over-leveraged investment markets that eventually seek equilibrium, bringing on the bear. Thus, Minsky showed the world that in the American economy, health invariably sows the seeds of sickness that is often accompanied by the decline of investment markets. This is in our nature because ours is a culture of excess and consequent austerity, of boom followed by bust.
Minsky’s use of the word “euphoric” preceded economist Robert Shiller’s use of a similar phrase for the title of his book about the 1990s bull market. The title, “Irrational Exuberance,” refers to the wildly inflated values of dot-com stocks in the tech bubble of that market. Irrationally exuberant investors took a big hit when this bubble burst in 2000. The irrationally exuberant have something in common with those who let fear of an inevitable decline prevent them from taking advantage of a bull market: They mistakenly believe that they need to be doing different things with their portfolios when the market is up or down.
As bull markets will always unpredictably turn bearish, the only way to take advantage of the bull while preparing for the bear is to reduce risk by using the same basic diversification strategy regardless of what the market is doing. This way, history shows, investors can get good investment returns in the long run. Rather than acting differently in different markets, investors should establish and maintain a thoughtful investment plan that gets them through up markets and down.
This means setting up a suitable asset allocation — a plan for how much of their money they should have in what investments. The single most important decision in this regard concerns asset classes — the different types of investments and the proportions of each. For most investors, this means nothing more than maintaining an appropriate balance between stocks and bonds. The right balance for you depends on your risk tolerance, which you can determine using any of various questionnaires. Many such questionnaires are available online from reputable financial services companies. If you’re skittish about volatility, you should have more bonds. People who sleep well at night when the stock market is going up and down may be comfortable holding more than half the dollar value of their portfolios in stocks.
Others, especially older investors, may want to have more in bonds, which are extremely likely to return their face value – the amount originally invested -- and to pay the interest promised. Thus, bonds guard against fears that the market may trend downward just as they retire and need to take money out to pay expenses. (However, the economic peril of a market drop during retirement is often exaggerated because liquidation is an ongoing process, not a one-time occurrence upon retiring.)
Diversifying portfolios into different types of asset classes is far more of a concern for those who are investing for five or ten years rather than for the truly long term. That’s because even if your entire portfolio is in stocks, you’re virtually certain to get good returns over a period of 20 years or more. In almost every measurable rolling 20-year period, the S&P 500 has returned 8.5 to 9 percent.
For most people, having everything in stocks isn’t enough diversification for them to feel comfortable, especially as they get older. Yet, with people living longer these days, a decision to invest everything in stocks at age 60 or even 70 can still take advantage of the strong likelihood of good market returns over long periods, but these investors are almost certain to be in for a ride that’s too wild for most people their age.
Decisions about what types of stocks to own and how much of each are often less important than asset-class decisions. But these are still important choices, especially for those with stock-heavy investment portfolios. Stock market allocation decisions involve how much to own in large companies versus small; growth versus value stocks; domestic versus international and emerging-market stocks.
These choices tend to matter more in rising markets. In a down market, protection against risk is afforded more by the allocation to different asset classes. That’s because, with increasing globalization, stocks of different types tend to decline together in a sinking market, but bonds may be fine when stocks are sinking.
Setting up an appropriate asset allocation won’t achieve its intended purpose if you continually change the targets, so you must have the self-discipline not to do this. If the stock market is flying high, you shouldn’t be tempted to liquidate half of your bond holdings to buy stocks. And when the stock market tanks, you should resist the self-destructive urge to sell at low prices. You may want to adjust your allocation a bit to reflect market changes, but you should keep it basically the same regardless of what’s happening.
It’s equally important to remember that your asset allocation will shift organically, so you must rebalance your targets to maintain it. In a bull stock market, your stocks will gain value to the point where, instead of your original allocation of 50 percent in stocks, they may grow to 60 or 70 percent. In that case, to maintain your allocation, you must sell 10 or 20 percent of the dollar value of your stock holdings (at gains from the uptrend), and invest this money in bonds. This would restore your original allocation.
Remember: Periodic rebalancing is the key to stock allocation. If large companies have done well, making your portfolio heavier on them than planned, you would sell some of these at a profit and then buy smaller companies, which would be selling at low prices if they haven’t been doing well. It’s a good idea to evaluate your portfolio for rebalancing once or twice a year.
Committing to an asset allocation means accepting somewhat lower returns in bull markets than you might get by investing more heavily in stocks (or in some types of stocks), but being reasonably assured of higher returns in bear markets. The solution of steadfast asset allocation works for both of our prototypical problem investors because it significantly reduces their tendency to be compromised by fear or greed.
Sound asset allocation is an investment strategy for all seasons. It frees investors from worry over what to do when the market shifts, and protects them from their own worst instincts.
Any opinions expressed here are solely those of the author.
Gary Droz is managing director of MainLine Private Wealth in Pittsburgh and Wynnewood, Pennsylvania, and has worked in financial services for more than 30 years. He previously served as president and managing director of Innovest Financial Management, and co-founded the Senior Insurance Institute, which presented educational symposia throughout southeast Florida with the goal of educating seniors and addressing advanced life insurance issues. Droz has a BA in communications from the University of Pittsburgh. He has been a guest lecturer at the Tepper School of Business at Carnegie Mellon University, where he discusses the discipline of investment management.