Sunday, December 12, 2010

Investing PART 2: Adjust the treble and base


Over more than a short time frame (i.e., a year) and less than a very long time frame (i.e., 10-20 years), re-balancing (i.e., re-allocating to a target mix) can increase returns for any level of volatility. But, the return as well as the volatility is very sensitive to how often the portfolio is re-balanced as well as the target mix.

The article cited in “Investing PART 1” suggests rebalancing once a year. Perhaps that’s because it is easy to remember, and it eliminates the risk of perverse timing. However, it also eliminates the possibility of more logical timing.

Logical timing has a lot to do with two things: your circumstances (e.g., your liquidity needs over time) and the state of the market. Each should be considered separately, but for reasons beyond me, people seem to feel a sudden increase in the need for liquidity exactly when asset prices are down. Don’t mix market performance and the subjective component of your assessment of your circumstances. Just keep them separate and you can beat annual rebalancing.

So, first let’s address your circumstances. If you are listening to some hard-driving rock and roll, you might want more base, but if you’re listening to some classical music, for goodness sake, rebalance. Similarly, if you’re young and investing for your retirement, don’t treat the investment allocation as if you were going to access the account next week. Rebalancing to maintain a target allocation without realizing that you are aiming at a moving target doesn’t make sense. Further, you should be moving the target according to some plan.

Once you start thinking about your circumstances such as your liquidity needs, you realize a year makes no sense for your total portfolio. Unless you’re totally myopic and only have one goal in life, your investments have multiple purposes. Every purpose (or objective) can’t have the same time constraints. The only condition where liquidity needs are uniform and don’t change over time is if you perpetually “live for today” to the exclusion of planning for a future. If you do that you’ll probably get exactly the future you planned for.

Further, every purpose can’t have the same annual cycle. In fact, individual years are irrelevant to most purposes. The irrelevance of annual cycles is widely known. For example, most mutual fund families don’t even offer “Target Date Funds” based on every year. For a good portion of ones life, individual years are largely irrelevant to retirement. What’s important to mutual fund families is selling their services. The funds they offer show that they know an individual year is irrelevant and they know potential customers know it.

Although the individual funds can manage the mix annually, or even daily if they want, the very offerings indicate a realization that for a good portion of one’s life, cash flow requirements, appropriate risk, and thus, the appropriate asset mix doesn’t really differ based on one year. Annual cycles, or whatever period the fund chooses for adjusting the asset mix, are an artificial construct. What the industry calls the “smooth glide path” just doesn’t reflect peoples’ reality.

One wonders whether the myth of the smooth glide path is just an excuse for more frequent trading, an artificial justification for management fees, or just an admission by the fund industry that they can’t understand asset market cycles. In any case, it is largely irrelevant and potentially dangerous if treated as gospel. Age (even within 5 or 10 year bands) is only one relevant influence.

Similarly, the amount of funds that one may need within a year is pretty stable (keep those funds in near cash equivalents). However, the portion of one’s portfolio that short run cash requirements represents is far from stable. In fact, for most of one’s life the dollar value of the funds one may need within a year is more stable than the portion of one’s portfolio that it represents. Unless you’re really screwing up your investments, the dollar value of short-run cash needs will usually shrink as a portion of your portfolio.

Here’s a wrinkle few people think about. If you believe you need to be able to “get to my money” at all times (i.e., always be liquid), you end up in one of two situations. Either you accept a low return on cash equivalents (and thus have less money to get to), or you risk and probably don’t achieve your goal of always being able to get to your money.

So, for two objectives, retirement and providing for short-run cash needs, annual rebalancing is irrelevant. Here are two simple and sensible alternatives. For money you may need (thus, most of your need for cash / liquidity needs), target a dollar figure. Ignore the portion of your portfolio it represents. For retirement, only look at data on returns over periods as long as the number of years you are away from retirement. There will be more on these topics in subsequent postings that address what to be rebalancing (i.e., what to buy as investments) and when to rebalance.

But, first let’s note that if an annual cycle makes no sense from the perspective of one’s personal perspective, it is even sillier from the perspective of market conditions. Annual is a convenient unit for showing the performance of different asset classes. However, what is convenient for communicating an idea is often over simplifying it for illustration. In this case, the point (i.e., different asset classes perform differently) is being illustrated using an annual period. However, annual has nothing to do with how long or how big the differences in performance are. Even more importantly, annual has nothing to do with why the performances vary.

If nothing else, this posting should have made clear that the reference to the article at the beginning of this posting wasn’t a recommendation. But, the article does provide a recommended approach that raises the right issues: what to buy, how to effectively diversify, when to rebalance, etc.. Also, the recommended approach is probably better than giving up and waiting for someone else to save you from financial hardship.

No comments:

Post a Comment