Thursday, February 4, 2016

The Three Fund Portfolio in 2016.

A good year to get to know yourself

Easy to manage if you know yourself
Get to know your reaction to volatility
Get to know your willingness to stick with your investment time horizon
Most importantly, get to know whether you can make money from stocks.

On February 11, 2014 this blog began a series of postings on “The Three Fund Portfolios.”  In the next two postings, a core portfolio consisting of three funds was described.  Both the rationale for holding funds and an example of a three fund portfolio were included.  The origin of that series was frequent requests by novice investors for some suggestions on how they could profit over the coming decade.  This is the kind of year when one discovers whether such a portfolio works for the investor.

A posting last month, “Watchwords for 2016: Time inthe Market Versus Timing the Market,” contained a forecast for market and economic conditions for the coming year.  For what it is worth, it argued that there is a high probability of a recession developing during next year.  If that is correct, 2016 should be a telling year for those invested in the three fund portfolio.

The reason it will be a telling year is simple.  As that posting stated, “It is easy to overestimate the change in behavior that an investor should make in response to an environment like we are likely to experience over the next year or two.  As successful investors know, the environment is probably less important than the investor’s objectives in determining what the appropriate strategy is…. It [the 2016 environment] necessitates actions that properly reflect the investors’ disposition toward volatility and willingness to stick with their chosen time horizon.”  

The only adjustment in behavior that the outlook for 2016 justifies for investor in the three fund portfolio is dollar-cost averaging.  Put simply, at the beginning of the year the investor should decide how much more they want to add their investments and then invest equal dollar amounts periodically.  Since the portfolio is composed of mutual funds, it is easy to divide by 12 and put 1/12 of the planned annual investment into the mutual funds each month.  If they have assigned equal weights to the three funds, they would invest each month in the fund that shows the smallest balance.  If they have been assigned different weights, the investments would just be in whatever fund needs to be rebalanced to maintain the assigned weights. 

Why, you might ask, would one increase one's exposure to financial assets (other than cash) if the outlook is that there is a high probability of a recession and a down stock market?  There are three reasons.  First, the outlook is always uncertain and the recession and down market may not materialize.  Second, and more importantly, if the market is down, that is exactly when one wants to be acquiring financial assets.  After all, one wants to acquire financial assets when they are cheap.  However, the overriding reason is the same reason that one acquired the three fund portfolio in the first place.  It is of little consequence what the market does in the next year if the purpose of the portfolio is to produce an increase in wealth five or 10 years out.  Viewed in a five or 10 year perspective, a rational investor would actually want the market to go down so that he or she could acquire more assets at a lower price.

It may be rational to want to acquire assets in a down market, but it is not a natural reaction.  Brain scans have shown that the natural reaction to negative news is processed in a totally different way from how the brain processes positive news.  The gut reaction to negative news is to assume a defensive posture or flee.  The equivalent investor behavior is to sell or to not invest.  The only successful approach to this natural response is to view a down market as positive.  It is, after all, positive from the perspective of one who wants to acquire assets.

It is also helpful to keep in mind that both behavioral economics and stock market folklore demonstrate a tendency of investors to want to participate in bull markets when prices are high and to want to avoid bear markets when prices are low.  Clearly, both behavioral economics and stock market folklore caution against a tendency to buy high and sell low, the opposite of the blueprint for success in investing.  Research using actual investor’s portfolio data has shown how widespread the tendency is. 

Interestingly, an article in the January 31, 2016 edition of BARON’S (Hulbert on Markets, Best Bear Market Strategy: Remain Invested in Stocks) pointed out that trying to time the market by consulting the newsletters of those who purport to be experts on the market does not help.  The supposedly experts who write newsletters are as likely to be wrong as right when it comes to market timing.  One has to wonder why investors would assume that they can time the market better than newsletter writers who have spent their whole career monitoring the market.  But Herbert's review of the newsletters supports a simple conclusion: “Crazy as it sounds, history shows it’s better to stay in the market rather than sell and try to time your return.”

Despite the prescription above, the purpose of this blog is not to tell people how to manage the money; it is, after all, their money.  Rather, all the points made above are background that one should consider as one makes decisions during 2016. It is perfectly legitimate to decide not to invest this year or even to sell the mutual funds and invest the money somewhere else.  But, by doing so, one is revealing important information about one’s financial management.  It is perfectly rational to move out of the mutual fund portfolio if one finds its volatility too distressing. 

That response should be viewed as an indication that the investor has trouble assessing their tolerance of asset price volatility and their ability to firmly anchor their investment horizon.  If that is the case, the investor should reconsider their commitment to the objectives that prompted the initial investment in the three fund portfolio.  One also should reconsider how realistic it is to expect to make money from investing in stocks if a periodic event like a recession and a down market is unacceptable. 

Down markets and recessions are a part of investing in equities.  In fact, investing during such events contributes substantially to investment success.  If an individual finds that they cannot accept the volatility and continue to focus on their long-run horizon, a perfectly acceptable, but more difficult, alternative is to just save more and invest in more stable but less profitable alternatives like bonds and CDs.

Disclosure: As explained in the postings introducing the three fund portfolio, the Hedged Economist’s principal investment focus is individual stocks and bonds.  In that case, the three fund portfolio is used as a place to park money intended for future investment in individual stocks and bonds.  Consequently, if as is expected, 2016 creates some opportunities to purchase individual stocks at bargain prices, there will be a temptation to let the balance of the three fund portfolio fall.  However, recognizing the value of the diversification that the three mutual funds provide, the plan for 2016 is to maintain the balance in the three fund portfolio by making additional investments using the dollar-cost-averaging approach described above.