… a forced flight away from stocks!

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I wrote a post a while ago about the Myth of Diversification – just another piece of financial ‘wisdom’ almost designed to keep you form retiring early / retiring rich …

Yet, despite the current melt-down that should prove that there is no real safety in diversification, the principles remain as mainstream as this comment from Francis illustrates:

That’s the idea behind diversification and re-balancing. If you invest in multiple things and periodically adjust the balance between them you are forced to buy low and sell high.

It really doesn’t take a genius to make a few million if you can just buy low and sell high

… but, it takes genius to know when to buy low and when to sell high!

Who knows where ‘high’ and ‘low’ really sit: they are relative, which serves (partially) to explain why market timing doesn’t work!

As the Dalbar Study shows:  mere mortals should not be in the business of trading stocks / timing the market; people who attempt this reduce their returns from 11.9% to only 3.9% … !!

No, we are simply investing for the long term, that’s why I asked Francis:

I agree with the “buy low” part … but, why “sell high”? Warren Buffett got rich by not selling his winners … he holds on to them.

Quite rightly Francis responded by pointing out that we aren’t Warren Buffett, saying:

Another reason to sell is that there are bubbles where the valuation of particular resources is out of whack. Wouldn’t it be a good idea to sell off at some amount before the peak of the bubble then repurchase after the crash? If you could reliably time the market you would sell it all at the peak and buy at the trough. I don’t have a crystal ball and I’m terrible at market timing. I’ve accepted rebalancing as a reasonable compromise.

As for Warren I know his favorite holding period is forever, but he is buying individual companies and is really good at valuing companies. He avoided the internet bubble like the plague, but I suspect that if he had stocks that became wildly valued he would sell them off.

But, if we really aren’t Warren Buffett, how do we KNOW when “the valuation of particular resources is out of whack”? Well, according to Francis, that’s when ‘rebalancing’ comes into play …

But, how does re-balancing provide a ‘reasonable compromise’ to the fact that we are all (WB aside) “terrible at market timing”:

Let’s say that you have $100,000 invested: 50% of your money invested in stocks and 50% invested in bonds.

Let’s then say that stocks ‘devalue’ by 50% overnight (a huge market crash) … in the case of an Index Fund, this could simply be a cyclic response to the market that has occurred many times in history.

Suddenly, your portfolio has shrunk by $25,000, so now you have $25,000 worth of stocks at post-crash prices and $50,000 worth of bonds (their price/value hasn’t shifted in this hypothetical crash). That is, you have 33% in stocks and 67% in bonds … so what do you do?

Well, you buy $25,000 more stocks … or, do you sell $25,000 of bonds?

The reality is that most people don’t have the $25,000 in ‘loose change’ to rebalance by topping up their portfolio, so they shift money FROM bonds INTO stocks.

Yippee … except, what happens when stocks recover and/or bonds dip?

In that case, you’d be taking yourself OUT of the stock market (a 9.2% – 11.9% annualized return, depending on who/how is doing the measuring) into the Bond market (a 4% annualized return?) …

… a forced flight away from stocks!

Would Warren Buffet do this?

Heck no! Warren Buffett doesn’t worry about market dips; he knows the market always recovers, as long as the underlying businesses keep making money. In fact, he looks at market dips as a buying opportunity (didn’t he load up on Kraft, while we were all bailing out of the market).

He identifies quality when he buys (bet he didn’t own any Enron), but, he recommends that you buy a little piece of all of America’s finest companies (a.k.a. an Index Fund, so even if you do happen to buy Enron, it’s only a tiny sliver of what you own), if you don’t know how to do what he does.

Warren doesn’t ‘rebalance’ his portfolio into cash (no dividends even, because cash/bonds doesn’t produce as high a return as his investments can) … and, he certainly buys more when the market dips and NEVER sells.

Here’s what to do:

If stocks are the asset class that you like and if you think that the stock market (as represented by an Index Fund or one or a few individual stocks, if you prefer) represents acceptable value:

1. Buy stocks … as many as you can afford; and,

2. Keep buying whenever you can afford more; and,

3. When the market dips, it’s ‘on sale’ … buy even more; and,

4. Never sell.

That’s it … now you are Warren Buffett.

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20 thoughts on “… a forced flight away from stocks!

  1. The main reason people diversify is to manage (lower) risk–which as you point out, lowers your expected return. By rebalancing periodically, you realign your portfolio to that initial risk level, instead of having it slowly creep into a more risky portfolio.

    Your beef with rebalancing appears to be that it accomplishes exactly what it intends to accomplish…lowering risk.

    “1. Buy stocks … as many as you can afford; and,

    2. Keep buying whenever you can afford more; and,

    3. When the market dips, it’s ‘on sale’ … buy even more; and,

    4. Never sell.”

    This is good advice…but #4 is probably unrealistic for most investors.

  2. @ Jeff – Why is # 4 unrealistic?

    I understand that when you retire you will need to withdraw up to 5% of your portfolio every year in order to live (ex-dividends) … other than that?

  3. I been Warren Buffett, I just don’t have as much money as him.

    However I do his strategy.

    1. Never lose money
    2. Don’t forget number 1

    I am on a buying spree. I also rebalance my portfolio by adding small caps

  4. AJC,

    I guess I have to comment on this one since I’ve been quoted so much.

    Consider two cases in the first you rebalance in the second you don’t:

    Rebalancing:

    Stocks Bonds Total Comment
    50K 50K 100K Initial conditions
    25K 50K 75K right after market crash
    37.5K 37.5K 75K After rebalancing
    75K 37.5K 112.5K Right after market recovery
    56.25K 56.25K 112.5K After rebalancing

    No Rebalancing:

    Stocks Bonds Total Comment
    50K 50K 100K Initial conditions
    25K 50K 75K right after market crash
    50K 50K 100K Right after market recovery

    Note rebalancing earned an extra $12.5K over doing nothing, it doesn’t compare to perfect market timing but there was no crystal ball required! Jeff pointed out rebalancing maintains the risk level. Was it less risky to hold half stocks half bonds? Yes, in the 50% market crash there was only 25K in losses rather than a 50K loss.

    What if the order was different?

    Rebalancing:
    Stocks Bonds Total Comment
    50K 50K 100K Initial conditions
    75K 50K 125K Market rises 50%
    62.5K 62.5K 125K Rebalance
    31.25K 62.5K 93.75K Market drops 50%
    46.9K 46.9K 125K Rebalance

    No Rebalancing:
    Stocks Bonds Total Comment
    50K 50K 100K Initial conditions
    75K 50K 125K Market rises 50%
    37.5K 50K 87.5K Market drops 50%

    Again rebalancing helps prevent losses over doing nothing. If you are invested in more than one asset class you should rebalance. We all know that there is no such thing as a free lunch though… What is the down side?

    By allocating 50% bonds 50% stocks you only get half the superior stock returns if the market is steadily going up. Rebalancing reduces risk at the cost of returns in the good years. The good years actually do outnumber the bad, even though it doesn’t seem like it right now! If you can withstand the risk you should keep a large percentage in stocks. I’m young enough that I don’t have a large % of bonds- and it sucks to take the full losses. However, I’m willing to risk it now for the full gains and I’m glad I get to buy shares at a steep discount now. As I get older I will be increasing the % of bonds that I hold and will be rebalancing.

    -Rick Francis

  5. @ Rick – You have to ask yourself the ONLY question that counts: will balancing (then re-balancing) help me get to my Number, if the answer is ‘yes’ and you believe that:

    a. market conditions will exactly reverse (they won’t), and

    b. ‘rebalancing’ will somehow lower your remaining risk (it won’t)

    … then, more power to you. But, I think you agree, more than disagree , considering your closing remarks?

  6. @AJC – Other than selling stock to provide a retirement income stream (which, unforetunately, for many people is going to be more than 5% after-tax), there are a couple of additional reasons I can think of:

    [Disclaimer: These are just off the top of my head…so I apologize in advance if anything is wrong.]

    1) It is difficult to find stocks that will provide a consistent 7-8% pre-tax (5% after tax) dividend return throughout your retirement years. Anyone can find stocks with high dividends today, but finding stocks now that will have high dividends over the next 30 or 40 years is more difficult. To take this example to the logical extreme, think of a 20 year old guy that wants to buy dividend stocks for retirement (at 65)…he’s going to have to select stocks today that will provide a 7-8% dividend in 45 years and then will consistently provide that same 7-8% dividend throughout his retirement years (for the following 10-40 years).

    2) Even assuming you could do #1, would it be in a stock investor’s best interest? Most stock investors want to maximize growth in their pre-retirement years usually with lower dividend stocks, and then maximize income (while preserving capital) during their retirement years usually with higher dividend stocks. In other words, they change course (sell) around their retirement to adjust for the needs of their new lifestyle.

    3) Required minimum distribution (after 70 1/2 years old) for tax-deferred accounts “can” force an early sale of stock. [Note: Often the distribution comes from dividends].

    At the end of the day, you can always diversify your portfolio with other income producing assets (bonds, annuities, real estate…you get the picture) and hopefully never have to touch the stocks. I, however, assumed that you weren’t considering diversifying based on the preamble of your post.

  7. @ Jeff – I agree, in principle, that we may need to make some portfolio djustments when we ‘retire’ (a.k.a. ‘life after work’ and ‘Making Money 301’) … we may cover some of the details in a later post).

    But, my post was about BUILDING wealth i.e. BEFORE retirement … what are your thoughts on ‘never selling’ for that stage?

  8. @AJC – I misunderstood your your “never sell” to mean do not ever sell, not just pre-retirement.

    “But, my post was about BUILDING wealth i.e. BEFORE retirement … what are your thoughts on ‘never selling’ for that stage?”

    I would agree with you if you had a 100% stock portfolio all in one asset class.

    If, however, you have elected to diversify your portfolio I would disagree and argue that you should rebalance to maintain your initial asset class mix.

    As discussed above, you add bonds to your portfolio to reduce risk. Failing to rebalance increases the your risk as time goes on…which is typically the opposite of what most investors desire. The reason you do this is not to maximize return, but to maintain the same risk that you had when you started.

    Another type of diversification is when you invest in different equity asset classes that have low correlation to each other, but the same expected long term return. One example is when a portfolio includes 50% SP500 and 50% EAFE. Since these two markets often do not move in concert, but have the same long term expected return, you can extract additional return through rebalancing over investing in either one individually (while reducing your risk). That is the theory at least…

  9. @ Jeff – Considering that I am ‘diversified’ on the London, New York, and Australian stock exchanges – and, in the tank on all three (for different timing/reasons) – I would have to disagree with this theory 🙂

    All we achieve by ‘diversifying’ from an investment (and market) that we know/understand/love is to lower our long-term returns, so I have to stick with my no diverification/rebalancing mantra.

  10. AJC,

    How’s the strength of the Aussie dollar treating you now? Your 7 Million is in USD or AUD?

    I didn’t expect the USD to rocket up the way it did… my diversifications in SGD and THB are getting hurt…

    Mike

  11. @AJC –

    “Considering that I am ‘diversified’ on the London, New York, and Australian stock exchanges – and, in the tank on all three (for different timing/reasons) – I would have to disagree with this theory”

    I’m sorry you are in the tank, but I don’t see how this short term event disproves a long term theory.

    “All we achieve by ‘diversifying’ from an investment (and market) that we know/understand/love is to lower our long-term returns, so I have to stick with my no diverification/rebalancing mantra.”

    You are assuming that you would always focus your investment on the better performing market. If you focus on an underperforming market, a diversified portfolio (with rebalancing) would provide increased return, probably with lower risk.

    The question is, for your holding period, can you consistently identify which market will outperform a diversified portfolio beforehand?

    [Note: Picking individual stocks is a whole different game, as the long term expected returns are much more speculative]

  12. @ Jeff – If we’re talking long-term, show me a ‘balanced/diversified portfolio’ that has outperformed a basket of high-quality US domestic stocks (heck, I’ll even take the entire S&P 500) over 30 years?

    I think you’ll be hard-pressed to come up with an average CGR of 11.9%, with only TWO 30 years periods as low as 8%. So, where does the higher risk lie?

    But, isn’t setting a strategy based upon risk rather than financial objectives putting the cart before the horse?

  13. @AJC –

    Asset classes like US Small, US Value, US Small Value, Emergining Markets, Foreign (Non-US) Small, Foreign (Non-US) Value, etc, all historically have higher long term returns than the SP500. Just mix one or more of these with the SP500, and the diversified portfolio will most likely beat the SP500 over the long run.

  14. @ Jeff – …and, your risk will likely go UP; there’s no such thing as a free lunch:

    – if you mix in high(er) return options (e.g. small cap) your RISK goes UP,
    – if you mix in low(er) risk options (e.g. bonds) your return goes DOWN

    Efficient market theory says that this MUST be the case 😉

  15. @AJC –

    “- if you mix in high(er) return options (e.g. small cap) your RISK goes UP”

    Generally, this is true. There are a couple of exceptions:

    1) If two asset classes are negatively correlated (have a tendancy to move in opposite directions during the short term, but over the long run provide their historical return) then your risk will go down even if you diversify into higher risk asset classes. The hard part is finding two asset classes that have been negatively correlated, and even harder to predict them going forward…

    2) This often used example, adds a small amount of equity (SP500) to an all bond portfolio. As you would expect, the long term return of the portfolio increases…but the long term risk decreases, e.g., with a 90-10 bond-stock split, or stays the same, e.g., with a 80-20 bond-stock split. This is one of the only “free lunches” in investing that I’ve read about that appears to be easily repeatable going forward.

    The real reason people diversify into higher risk asset classes is to increase their return per unit of risk. Even when a higher risk asset class increases the overall risk of your portfolio, the excess return is disproportionately large when compared to the excess risk. Thus, overall the return per unit of risk increases, helping you to maximize the amount of return you receive for the risk that you take on. Put a differently way, if you tried to find a single investment that provided the same return as a diversified portfolio, it would most likely have a higher associated risk, and if you tried to find a single investment with the same risk, would most likely provide a lower associated return.

    This, of course, doesn’t mean anything unless the new return is something that you desire.

  16. @ Jeff – ‘This, of course, doesn’t mean anything unless the new return is something that you desire.’ Indeed. 🙂

  17. AJC, I’m surprised you haven’t talked more about investor psychology. All these investment systems and tricks are nice, but in my view, I’ve come to realize the “strategy” may actually be a small component of future success.

    Let me give you an example.

    I was heavily short many bank stocks starting in July. At some point I had more than 40% of my portfolio dedicated to various shorting strategies, based on much analysis of what was going on. A fair amount of that 40% was leveraged with options and 2x ETFs as well.

    Then, as you may know, in September, the government decided to ban shorting any and all bank stocks. I was completely burned out at this point, panicked – and the following day closed all my shorts, keeping only some long positions which I deemed “safe”.

    Over the ensuing two months I watched in horror as I saw my shorts would have netted a 30-40% portfolio return, but I instead netted a 10% portfolio loss on my longs! I was so afraid of losing money, and yet my behavior ended up causing exactly that. And like a deer in headlights I couldn’t muster the courage to short the market as it slid forward in those two months.

    What’s the moral of this story? In my view, anyone who wants to follow this blog’s stated goal, aka “7 million in 7 years”, and expects to use the stock market as a tool to achieve that purposes – MUST have a resonably high risk tolerance. The ones who succeed seven years from now will not be the smartest ones, or the ones who figured out the best system, the best portfolio probability curve. They will be the ones with decent systems and discipline but outstanding ability to stand tall in the face of enormous adversity (aka portfolio losses).

    That equates to high risk tolerance. Which is ok, because after my adventure, I now firmly believe risk tolerance can be learned and is not innate. It can be managed, practiced and developed. And learning risk tolerance probably involves having to go through a few heavy losses to learn the process. I lost maybe 70,000$ in the stock market now – a substantial part of my net worth. But you know? I realize, I’m still here, I’m still standing, and losing 70,000$ sucks A LOT – but I’m not dead for it. It’s no longer an unknown.

    Just my two cents! Engaging in intelligent, risky behavior is what this blog is all about in my view :-).

    Keep up the good work.

  18. @ Muzie – Great points, great story and great advice. The reason why I don’t talk much about investor psychology is that I am not an expert … I have the experience of one: me. But, through sharing similar stories on this blog and others, as a group, we can start to see the underlying ‘psychologies’ that will see who succeeds and fails with the systems as I unveil them.

    One observation that I can make: I am constantly surprised by which of my posts seem to attract the most attention, and the ones that seem to gather little. If I put an ‘importance rating’ on each and asked my readers to do the same, I wonder how well they would match?!

    Thanks again for putting ‘pen to paper’ … keep it up! AJC.

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