Thursday, May 17, 2007

Rules for Tweaking Your Portfolio and Market Timing

Recently in an email exchange with a friend, I mentioned that my bond allocation is somewhat lower than the normally recommended amount because I did not believe it was a good time to invest in bonds. Immediately, there came a reply asking whether this meant I am a "closet market timer"?

I thought this an interesting question, and I've spent some time thinking about it since. Generally, I believe trying to time the market is a big reason why most investors underperform the market averages, a prospect that seems counter intuitive. As a result, I usually think of market timing as a bad idea.

And yet, I enjoy reading the news and trying to anticipate what it may mean for the markets, the economy and society as a whole. And that often results in a desire to act on these thoughts to tweak my portfolio.

If you don't enjoy the kind of rumination described above, don't worry. I sincerely believe that the systems I've outlined in my previous posts on managing your portfolio through allocation, rebalancing and dollar-cost-averaging-on-steroids will help you outperform the markets while spending no more than a few minutes per month, or even a few minutes per year, thinking about your financial assets. In that case, there is no need to read further. The systems I have outlined are a kind of autopilot for market timing, when you think about it.

But, if you like to study the news and anticipate what it may mean in the future, it is possible to improve the performance of your portfolio without substantially increasing your risk (or perhaps even decreasing your risk). Before you consider doing so, however, I'd recommend you consider setting some ground rules.

Following are my ground rules:

  1. Stay true to the spirit of your allocation. Allocation is your main tool for managing risk in your portfolio, so you should avoid the temptation to stray substantially from it, thereby increasing your risk. My decision to have a reduced exposure to bonds could lead to substantial risks if it meant I invested more in stock, but I believe cash, in the form of money market funds or short term CDs, are a reasonable proxy.
  2. Tweak in ways that are contrarian, rather than following the crowd. I have less bonds because the market seems to have priced in significant decreases in interest rates. Many of the experts seem to be saying the same thing. I disagree, therefore I see reducing my bond holding in favor of CDs being a contrarian move that fits better with my expectations. I've had above average exposure to energy for the same reason over the past few years...the oil and gas companies seem to be priced based on $30-40 oil, and most people seem to think prices are unreasonably high, but I believe prices will remain reasonably close to where they are. (See my Energy Guru blog at for more on my logic in this area.) Let me just reemphasize my warning here-Do not listen to the news and decide to tweak your portfolio in a direction recommended by all the experts. If everyone seems to agree on a direction it is probably dangerous to move in that direction...the end is likely near for that run. The tendency to follow this path is the main reason market timing often leads to underperformance.
  3. Tweak for personal reasons. If you notice everyone you know is suddenly using a new product by a company you never heard of, it might be worth checking into. I'm familiar with the oil and chemical industries, so maybe I understand the business a little better than most. In the past few years, I've been moving toward dividend paying blue chips. The decreased risk and low-tax income meets my personal needs. At the time, this was also contrarian, since blue chips seemed to be out of favor. Interesting that blue chips seem to be popular these days, with the Dow hitting new highs almost every day. And the Yahoo Financial poll results today indicate that 65% think the Dow will be higher at the end of the year vs 24% who expect it to be lower. Hmm, I'll have to think about that!
  4. Tweak only at the margins. A few percent here, a few percent there can give you the satisfaction of acting on (and perhaps benefiting from) your beliefs without betting the farm or putting your financial independence at risk.
  5. Act only on a strong conviction that goes against the conventional wisdom. Perhaps you see this in the examples I've mentioned. Don't act based on a few articles, or the conviction of an expert.

So, there you have the Personal Finance Guru rules for market timing. Maintain your allocation, think contrarian, think personal, work at the margins, act on strong convictions. Using these rules, I believe you can do a bit of market timing or use your judgement to personalize your portfolio without much risk, and possibly to improve your returns.

Monday, May 7, 2007

The Crash(s) are coming! What should you do about it?

Thanks to all those who participated in the comments and discussion on my last post. After reviewing the article and comments, as well as email and discussions with friends, I think is is worthwhile to summarize the conclusions and take a look at what you can do today to take advantage of what the future holds.

First, the summary.:

  • Boomers have had a significant effect on markets of all types and it is reasonable to expect that to continue as the bulge makes its way through retirement. This may well include underperformance by the stock market and other investments, but it seems likely to tighten the US labor market and present greater opportunities for those in it.
  • Markets rise and fall, and it is reasonable to expect that to continue. Included in this assessment are markets of all kinds, from stocks and bonds to real estate and commodities. Booms and crashes alike are regularly fueled by imbalances. The only questions are severity, duration, timing, rotation and what we should do about them.
  • Leverage can increase returns, but it also increases risk. In boom times it can create outstanding performance. In crashes it can be disastrous.

I know most of the above is pretty obvious, but it is amazing how often these facts and their results are ignored or obscured by those selling various schemes. For more details than shown in the summary above, please check out my previous post and comments. More important than understanding the above facts is understanding what you should and should not do about them. That is where I really want to take the discussion.

It is very tempting to conclude, based on the above, that the way to invest is to ride each boom to its crest and them jump to the next booming market, repeating this process as markets rotate. And, in fact, if you could do this consistently it would be the route to quick riches. Unfortunately, this process looks simple in hindsight, but is virtually impossible to maintain in real time. There are a number of reasons for this, but I think the key reason is that it is very difficult emotionally to jump ship as a market is hitting new highs, or to climb on as a market is near a bottom. It is human nature to believe that recent history will be repeated. If a market is up dramatically this year, it is almost impossible to believe it will reverse tomorrow. If a market is down dramatically it is almost impossible to find the courage to buy. Worse, most of the experts will reinforce this natural inclination. When markets are cresting, most of the media coverage will be euphoric, when markets are down the media will be negative.

I mention above that getting into booming markets early is easy in hindsight, and most sales pitches take advantage of this phenomenan. They look back in history, see what is obvious from this vantage point and paint a picture of what was possible based on this "obvious" insight. Then, they convince you they have the insight to repeat the process. After many years of observation, it has become obvious to me that they rarely, if ever, do. Trying to find the gold in this haystack is like going to the might get lucky now and then, but over time you will almost certainly lose.

So, what can you do to take advantage of the obvious facts? There are some proven tactics, which, while they won't make you rich quickly, will help you perform better than most, and will help you become financially independent over your life time. Here's what you need to know to get there.

  • Smile and take with a grain of salt what you see in the media and from get-rich-quick artists about the best investment today.
  • Use leverage only rarely and puts you into the casino realm. You want to be in the long term financial success realm.
  • Invest broadly in an asset allocation that reflects your timing and risk tolerance. In light of the baby boom phenomenan, I believe more than ever, this includes significant international exposure
  • Add to your investments and rebalance regularly. In so doing, you will, in affect jump from the crests to the bottoms. But, again, in a way that keeps you out of the casino realm and on the track to long term success. This method allows you to take advantage of the above facts, while reducing risk. And, it satisfies the emotional need to do something in the time of booms or busts, while taking the emotion and the need for brilliant decisions out of the jumping process.

Based on my experience, the simple steps above are what is necessary to profit from the booms and busts that are surely coming. If you need help with the details of how you go about executing these steps, you'll find it in my previous posts, or you can post a comment or question. The expertise is out there reading and ready. I'm also open to alternative approaches. Let the discussion begin!