We all know the basics – design an asset allocation plan, ignore market fluctuations, and stick with the plan for the long term. In other words, become a buy-and-hold investor. But in an era where everything seems to change overnight, is it realistic to expect to find investments you’ll be comfortable owning for years or even decades?
Before you answer that question, you need to consider whether it’s possible to reliably time the market. Unfortunately, it’s a difficult strategy to implement for a couple of reasons:
No one has been able to consistently predict where the stock market is headed. Many try, but so many factors affect the market that even professionals watching the market full-time find it difficult to time the market with any degree of accuracy. In retrospect, everything seems crystal clear. Are you still upset you didn’t get out of technology stocks in 2000? While we now know that was the market top for technology stocks, very few recognized that in 2000. Also, significant market gains can occur in a matter of days, making it risky to be out of the market for any length of time.
Frequent trading seems to reduce, rather than increase, returns. Several studies of investor trading found that investors who trade more frequently have lower portfolio returns than those who trade less frequently. A recent study found that for the 20 years ending in 2007, the average equity fund investor earned an annualized return of 4.5%, compared to an annualized return of 11.8% for the Standard & Poor’s 500 (Source: Fortune, November 10, 2008).* Why? Investors tend to buy hot sectors and sell underperforming investments – the opposite of a buy-low-and-sell-high strategy. Also, trading results in a taxable event. Even with capital gains rates at 15% and the highest ordinary income tax rate at 35%, taxes significantly reduce your portfolio’s return.
Rather than trying to time the market, devise an asset allocation strategy that is right for your situation and then purchase investments to implement your strategy. Your asset allocation should include target percentages for each asset class with ranges of allowable variances from the target. If the percentage of the portfolio for a given asset class is higher or lower than the outer bands of the range for that asset class you should buy or sell enough to bring it back in range. Periodic rebalancing will force you to sell some of your winners and move those dollars to asset classes that are not performing as well. Markets move in rotation and different investment styles will perform well at different times and under different market conditions.
Monitor your holdings. Investments change over time, whether you are holding individual stocks or bonds, mutual funds, ETFs, alternative investments, or other holdings. In the case of mutual funds for example, make sure the fund’s objectives have not changed since your purchase. If the fund is actively managed, has the management of the fund changed? Have fund assets grown or contracted drastically? In the case of a small or mid cap fund a dramatic increase in fund assets should be a big red flag for shareholders. The era of buying any investment vehicle and forgetting it is long gone. Even if you end up buying and holding, this is an active strategy.
Your asset allocation likely will change over time. The market activity of the past several months has reminded us that managing portfolio risk is a key element of investing. Review your asset allocation periodically in light of your overall financial goals. Our allocation generally becomes more conservative as we age. Are you taking too much risk for your age? Do you need to take more risk to achieve your goals? A financial advisor might be able to help answer these questions.
* The S&P; 500 is an unmanaged index. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.