Talking Heads

I thought I would share a good post from Vanguard’s Advisor Blog written by Fran Kinniry last week.  To be honest the song “Once in a Lifetime” by the Talking Heads used to drive me crazy, but is very applicable to investing.  The main theme is understanding your tolerance for risk, time horizon and goals.  I hope you enjoy:

One of my favorite bands when I was growing up in the 1980s was the Talking Heads, led by front man David Byrne. And one of my favorite songs from the band was, “Once in a Lifetime,” with the chorus “Same as it ever was, same as it ever was, same as it ever was”.

I frequently get asked by financial advisors and the news media if the global financial crisis (hopefully, a once-in-a-lifetime event) changed investor behavior. My answer is a resounding no—it is the same as it ever was.

Investors continue to follow returns. In my August 6 blog, The great temptation of the great rotation, I sent up a warning flare about the strong returns of the stock market and the likely effect they would have on investors’ views of this asset class. At the time, stock mutual funds’ cash flows were relatively weak compared with the levels over the prior two decades, while bond mutual funds’ cash flows remained very strong. Fast forward a few months and we are now seeing—for the first time since the onset of the global financial crisis—significant positive cash flows into stock funds and negative flows out of bond funds. As you can see in the chart below, investors tend to flee stocks during downturns and become enamored with them again after upswings—same as it ever was.

Buying stocks now, however, may actually run counter to what many prudent investors should be doing. As the chart below shows, since the depth of the 2008–2009 bear market through October 31, 2013, the global equity allocation for investors increased from 38% to 57% , which exceeds the 20-year median equity allocation of 51%. This increase was driven by the fourth-largest equity bull market in history, which so far has provided a cumulative return of 198%₁ and has led to equity valuations that look challenging (see October 24, 2013 blog).

So what is an investor to do? I would start with the suggestion that you should review your asset allocation. If you are like most investors (i.e., with an equity-heavy portfolio), you will most likely need to direct new cash flows to bond mutual funds, selling stock mutual funds to maintain your asset allocation, which is the exact opposite of where moneys are flowing today.

Let’s take a quick review of rebalancing. Historically and mathematically, rebalancing opportunities occur when there is a wide dispersion between the returns of different asset classes, such as stocks and bonds. For example, a 60% stocks/40% bonds portfolio would have had a rebalancing event from stocks to bonds₂ in 22 years during the period from 1926 through 2012 (one in every four years). In 18 of these 22 years (80% of the time), the stock market returned more than 20%, and in 13 of those years (60% of the time), the stock market returned more than 30%. Remember, rebalancing is not about maximizing returns, reversion to the mean, or market forecasts—it is about maintaining the risk and return characteristics of the portfolio an investor selected based on his or her unique time horizon, risk tolerance, and financial goals.

I certainly empathize with investors since rebalancing usually seems counterintuitive at the time when it promises to be most effective. It can be difficult to implement from a behavioral standpoint and requires incredible discipline. With the U.S. stock market up 198% since its trough, coupled with the considerable uncertainty about the impact of rising interest rates on bonds, it is understandable that investors may have a hard time selling stock funds and committing more capital to bond funds in order to rebalance their portfolios.

In fact, it is very common following significant gains in the equity markets for investors to question the benefits of rebalancing. Perhaps they think that “it’s gonna be different this time.” While it might be, it is much more likely to be the “same as it ever was.”

I would like to thank my colleagues, Colleen Jaconetti and Yan Zilbering for their contributions to this blog.

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₁ As defined by the MSCI Broad Market Index.
₂ This example does not represent the return on any particular investment. Assumes a portfolio of 60% stocks/40% bonds. Stocks are represented by the Standard & Poor’s 90 from 1926 to March 3, 1957, the Standard & Poor’s 500 Index from March 4, 1957 to 1974, the Wilshire 5000 Composite Index (January 1, 1975, through April 22, 2005), and the MSCI US Broad Market Index (April 23, 2005, through December 31, 2012). Bonds are represented by the S&P High Grade Corporate Index (1926 through 1968), the Citigroup High Grade Index (1969 through 1972), the Lehman Long-Term AA Corporate Index (1973 through 1975), and the Barclays Capital U.S. Aggregate Bond Index (1976 through 2009). All returns are in nominal U.S. dollars. There were no new contributions or withdrawals. Dividend payments were reinvested in equities; interest payments were reinvested in bonds. There were no taxes. Assumes annual rebalancing with a threshold of 5%.
Sources: Vanguard’s calculations, using data from Standard & Poor’s, Dow Jones, and Barclays Capital.
₃ As defined by the MSCI Broad Market Index.

Notes:

All investing is subject to risk, including possible loss of principal.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Diversification does not ensure a profit or protect against a loss