Allocating your hard-earned capital, the smart way

There has probably been a time where you’ve heard someone discussing a stock or mutual fund that has had big returns, or perhaps an advisor who has outperformed the market over a given year or so. Naturally, we’d like to flock to that expert advisor, or that superior stock or mutual fund to realize some of those gains as well. There would probably be something wrong if we didn’t feel compelled to jump in and make some money right then and there. Unfortunately, chasing investment returns can be one of the worst mistakes an investor can make. And too often this impulse occurs when an investor has not established a plan of some sort from the outset, making decisions willy-nilly as though allocating one’s hard-earned money in the markets was not an important matter.

Asset allocation is one of the most important aspects to investing, and for good reason as it’s directly derived from an investment plan and a risk tolerance profile. Risk and return are inseparable; the more risk one takes in the market, the more return one should expect to receive. This is axiomatic for most things in life as well. There has not been a single entrepreneur who has had an aversion for risk, unless of course they stood to lose no money along the way. The same risk/return trade-off holds true when determining the asset mix of your portfolio.

All things in moderation

Big returns over a long period of time will most likely not come from holding an entire portfolio of treasury bonds. Nor will an all-bond portfolio result in crippling losses, as the average loss over the 88-year period ending in 2014 was just a mere 5.4%. Compare this to an average loss over the same period of an all-equity portfolio of 9.7%. Averages, however, can be misleading especially over such a long period of time.

Figure 1 highlights how devastating one-year losses can be when a portfolio consists of all stocks.1 Incurring a loss of 43.5% would undoubtedly impact both the short- and long-term investment goals of someone trying to save for a new house in the next couple years, or even retire ten or fifteen years down the road. On the other end of the spectrum, an all-bond portfolio has only lost about 8% over its worst one-year period during that time period.

Figure 1. Asset allocations and spectrum of returns

Of course, these are two extremes, so a more likely asset allocation mix probably lies somewhere in the middle. For example, with respect to a couple in their 30s, a good rule of thumb is to allocate your age in bonds—or 30% of their total capital—plus or minus a few percentage points depending on their time horizon and risk tolerance. Therefore, as we can see from the diagram, a 70/30 equity-bond mix would average around 9% on any given year; however, the roughly 72% range of returns could mean a substantial loss of about 31%, or a big gain of around 41%, for any given year. The key question is: how much can you stand to lose before you have to sell out? In other words, if you can’t stomach losing 31% of your capital, you shouldn’t allocate 70% of your money toward equities. On the flip side of this, perhaps the notion that if you’re looking to be in the market for the next 15 to 20 years, and a decline of this sort might offer you a chance to buy even more securities at a cheaper price, you would be able to reduce the average cost per security and end up buying at lower price points than if you had not bought at those lows.

Sell down to the sleeping point

There’s an old adage that says you should sell down to the sleeping point. Stated another way, this just means that if losing 30% will keep you up at night, it would be more prudent to pare down the equity holdings and replace them with bonds. This doesn’t guarantee a less-than-30% loss, but historically, it does mean that there’s probably less of a chance that it would happen.

Similar to sustaining market losses, many investors can’t handle missing out on big market runs, particularly when it appears as if everyone else is profiting from it. And this is when most people start chasing past performance, altering investment plans, and ultimately selling low after buying high; a recipe for disaster. Standard & Poor’s publishes the S&P Persistence Scorecard twice each year, which tracks performance of actively managed mutual funds over several years.2 Of the 1,421 domestic equity funds in September of 2009, only 6.47% remained in the top half just five years later. Random expectations would suggest a repeat rate of about 6.25%. So, you could literally throw darts at the mutual fund section of the newspaper and expect to do just as well as the “expert” fund managers. For shorter time periods, the result isn’t much better. Of the 692 funds that were in the top quartile in September 2011, just two years later only 7.23% remained in that top spot. Chasing past performance does not pay off.

In short, a more viable plan is to determine an appropriate asset allocation mix that is in line with the risk of loss you’re willing to accept, modifying the plan to account for investment-related goals, and buying more (or selling more) during market decreases (increases). Nothing is worse than repeatedly buying high and selling low. It’s the exact opposite of attempting to buy at low prices and sell at higher ones along the way, which is a winning strategy over any timeframe.

1. Vanguard Research, Best Practices for Portfolio Rebalancing, November 2015

2. S&P Dow Jones Indices Persistence Score, December 2013