Sunday, August 09, 2020

Part 2

In last week’s column I explained why I believe that market timing as a strategy is a fool’s errand. By jettisoning one’s portfolio out of fear, greed or plain hubris, an investor quite often ends up regretting their decision. Market timing is a mistake in the category of questionable reactions to market dislocations. This week I will be discussing a mistake that investors make even before an exogenous event impacts the markets.

It is important for investors to position their portfolios taking into account their financial condition, risk tolerance and investment objectives. During calmer markets, a misalignment of one’s positioning may have little to no consequences. But when markets are in disarray, investors can suffer damage to their financial plans and goals that may prove difficult to repair.

When initially building an investment portfolio, the primary decision one faces is how to construct a portfolio with an “asset allocation” that is consistent with one’s long-term goals. Asset allocation is the process of strategically dividing one’s portfolio into a mix of stocks and bonds that is appropriate for one’s age, employment status, income needs, tax bracket and risk tolerance, among other considerations. While asset allocators include an array of asset categories beyond stocks and bonds, such as precious metals, foreign stocks, private equity and real estate, we will focus on a more basic asset allocation strategy for ease of illustration.


Let us consider how an optimal asset allocation strategy can vary widely across investors types. For example, when a college graduate enters the workforce and begins to tuck away part of their salary for retirement, they will be looking at a multi-decade investment time horizon. Most investment advisors recommend that young investors allocate the lion’s share of their portfolio to stocks and a relatively small portion to bonds. Conversely, investors who are nearing retirement age are advised to gradually “de-risk” their portfolio. They should be gravitating to a meaningfully more conservative asset allocation by overweighting bonds and other fixed income securities. In any case, investors should regularly monitor their portfolio to ensure that it is within the range of their asset allocation target.

Needless to say, a retiree who is dependent on generating income from their portfolio and has a 100% allocation to stocks faces financial risk should a bear market in equities unfold. In order to make up for a shortfall in income generation, the investor could be forced to sell stocks at an inopportune time in order to ensure meeting his living expenses. Thus, having a proper asset allocation going into an equity market downturn is crucial.

Even if one has the proper asset allocation, there is another opportunistic aspect to monitoring the portfolio. By carefully monitoring one’s asset allocation, one could actually take advantage of market volatility.

Let us assume that we have an investor that has a target allocation of 60% equities and 40% bonds. Let us also assume that the investor was appropriately allocated to this target allocation at the beginning of 2020. By virtue of the sharp decline in the stock market during the first quarter, and the relatively muted performance of bond investments, the new asset allocation may have drifted to a mix closer to 50% equities and 50% bonds by the end of March. A disciplined rebalancing approach would impel the investor to shift some of their assets from bonds to stocks. This would have facilitated a return of the portfolio to the target levels. (Coincidentally, this would have also resulted in his purchasing of stocks near the stock market lows.)

Now we have witnessed quite a rebound in stock prices during the second quarter of 2020. If the investor had rebalanced at the end of the first quarter, they would now have an allocation to equities above their target allocation. Another rebalancing at the end of the second quarter would have shifted some assets back from stocks to bonds. (Coincidentally, this would have resulted in selling stocks closer to the market highs.)

As a result of rebalancing in a proactive manner, the investor will have earned a profit by buying low (at the end of March) and selling higher (at the end of June). The investor will have earned a profit while maintaining the asset allocation strategy. To be sure, while this will not generate a profit every time, it does instill a sense of discipline that can help investors achieve their investment goals over longer periods of time.

How often should one review their portfolio asset allocation? I would recommend that it should be reviewed at a minimum of once a year. However, when the markets are in disarray similar to early 2020, I would suggest reviewing the portfolio more regularly. One should not “overtrade” the portfolio. However, one should have a minimum and maximum allocation threshold for each asset class, which would trigger a rebalancing response.

Even if the markets are relatively quiet, it is important to understand that movements in the stock market (and to a lesser extent the bond market) will have the effect of automatically shifting one’s asset allocation mix. By not maintaining one’s asset allocation discipline, one can experience what I call “asset allocation drift,” where one’s portfolio is moving further and further away from their target allocation.

Asset allocation drift could prove dangerous, especially as one approaches retirement. Let us say that at age 50 one had 60% of their portfolio in equities and 40% in bonds. If equity returns surpass bond returns, the investor would see their allocation to stocks steadily increase, even as their need for retirement security is of increasing concern. By neglecting to rebalance, the investor could inadvertently increase portfolio risk at a time when they should be in a de-risking phase.

Regardless of one’s age or financial situation, one should have a proactive asset allocation strategy and maintain that discipline through time and market cycles. A focus on maintaining one’s investment strategy will likely result not only in lessening one’s financial insecurity, but also in “many happy returns.”

Jonathan D. Caplan, a former Wall Street executive, is president and founder of wealth management firm Caplan Capital Management, Inc. with offices in Highland Park and Hackensack. He holds a BA from Yeshiva University and an MBA in finance from New York University Stern School of Business. You can find other recent investment articles by Jonathan at www.caplancapital.com/blog.

The views presented are those of the author and should not be construed as personal investment advice or a solicitation to purchase or sell securities referenced in this market commentary. The authors or clients may own stock or sectors discussed. All economic and performance information is historical and not indicative of future results. You should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice. All information is obtained from sources believed to be reliable. However, we do not guarantee the accuracy, adequacy or completeness of any information and are not responsible for any errors or omissions or from the results obtained from the use of such information.