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.

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