It happened again. I was reading a story about the apparent hazards
that are expected to derail an asset class that's in my portfolio and I
thought, gee, I better sell. The article presented a strong case for
seeing red in the near future. But then I remembered that the asset
class is just one piece of my diversified portfolio, and that my
rebalancing strategy will take care of any extremes in the various
components. Thinking about the big picture for my personal asset
allocation reminded me that the article wasn't all that applicable to my
situation after all. Once again, my initial emotional reaction turned
out to be not so helpful after all in money matters.
Stories about the alleged opportunities and risks for a given asset
class at a specific point in time are a staple in the financial media.
Some of them are actually right, but not always. I should know, since
I've been known to write a few of these gems through the years. But
every time you read one of these articles you should remember that the
information is almost always presented in a strategic vacuum in terms of
your portfolio. That's inevitable, of course, since only you
know what's in your portfolio, and so only you know how much relevance,
if any, applies when it comes to current news on a relatively narrow
slice of the world's capital and commodity markets. In other words,
analyzing assets in isolation of your total portfolio can lead to bad
[Related -These Small Caps Now Hold Deep Value]
The caveat wouldn't mean much if we had something approaching near
certainty that the analysis du jour for a given asset class was
accurate. In that case, we could throw all the standard rules about risk
management out the window. In the real world, of course, imperfection
infects every effort to peel away the cloud of unknowing on the morrow.
Fortunately, there's a reasonably effective solution: asset allocation
[Related -Russell 2000 Showing Relative Weakness at the New Highs]
When you hold a broadly defined portfolio of the major asset classes,
you're always prepared to exploit return volatility, regardless of the
source or whether it's a total surprise or widely anticipated. Once you
wrap your head around this idea, many of the updates from the usual
suspects lose their relevance for your portfolio.
We can and should debate the details for structuring a portfolio in
terms of defining asset classes, how many to own, etc. But the key point
is that in order to harvest risk premia from price volatility, you
first must own a broad set of assets. That means owning a mix of winners
and losers on a regular basis, and not getting too worked up over any
one piece of the portfolio at one point in time. Ideally, you'll own an
expansive set of assets that maximize the supply of low and negative
correlations across the portfolio--an essential feature for profiting
from rebalancing opportunities.
Yes, it all boils down to buy low and sell high. Duh! But obvious
lessons all too often remain elusive for investors on the road to
earning a decent return. One reason is there's a tendency of going off
the deep end in deciding that a certain asset class should be avoided,
or that another asset is a sure thing and so it's time to overweight in
the extreme. The problem is that if you spend any time studying the
historical record of all the asset classes, in context with one another,
it's clear that surprises are a constant. The implication: own
everything and focus like a laser beam on managing the mix.
To take a recent example: US Treasury bonds. How many times over the
last several years have you heard that they're in a bubble? The
countless warnings sounded reasonable. But did you also know that
Treasuries have delivered handsome returns in recent years? The iShares Barclays 20+ Year Treasury Bond ETF (TLT), for instance, generated a 14% annualized total return over the last three years through January 9.
What should you do now? The same thing you should have been doing all
along: diversify and rebalance. If you've owned Treasuries for, say,
the last three years, you should have been rebalancing the portfolio
periodically. If so, you've been harvesting some of the tidy gains from
government bonds recently and in the process kept a lid on the Treasury
allocation. Same old, same old. It's not exciting, but it works.
Suffice to say, you can always find smart people telling you to buy,
or sell, just about anything. But stellar track records based on this
advice, alas, tend to be the exception.
Don't misunderstand: it's essential to sell overpriced assets at some
point and favor the underpriced ones. In fact, that's everyone's goal.
Results, of course, vary dramatically. One way to systematically boost
the odds of earning average-to-above average returns relative to the
crowd is to diversify broadly and rebalance periodically. The first
phase of this one-two strategy is easy: buy a varied mix of ETFs, for
instance. The second phase is tricky, although you can probably do quite
well with a simple rebalancing strategy of, say, returning the asset
weights back to pre-set levels once a year, or something along those
lines. This is one simple way to keep bubble pricing at bay, while also
making sure that you'll also ride the wave when the today's out-of-favor
asset classes mounts a revival.
Truth be told, there are numerous intriguing possibilities for
designing rebalancing rules to juice performance, reduce risk, or both.
But even the world's greatest rebalancing strategy faces serious
headwinds in a portfolio that holds too few asset classes. Keep that in
mind the next time you read an article that seems to hold all the
answers about one asset class. Context is critical in portfolio design
and management, even if it's routinely overlooked in today's hot