In my last column, we reviewed the importance of rebalancing your investment portfolio back to a target allocation periodically. This process reduces the risk of the price action of the financial markets from inducing too much risk to your portfolio through the segments which have been performing well occupying too much of the allocation as they edge toward the next inevitable price correction. If applied in a disciplined manner, it is also a way to keep our subjective excitement over an asset class's perceived potential from skewing the allocation through excessive purchases. Let's face it; you'll be wrong as often as right in these cases.
There are some old rules of thumb, which I believe may be a little too conservative, but are worth considering as a starting point. One of these is to take your age away from 100 to determine you maximum allocation to equities. So, a 60-year-old couple (you can average the ages of spouses) would have a maximum allocation to stocks (or other risk assets like REITs commodities, etc) of 40 percent.
I don't believe the above method will hurt anyone, but may provide a lower performance than they might achieve with a increased equity (risk asset) bias. As a hypothetical example, using the assumption that the long-term average annual return for stocks will be about 9 percent and that bonds will average about 5 percent, the 40 to 60 split of equities and bonds would be expected to return 6 to 7 percent average annualized return. For perspective, a reversed allocation of 60 to 40 equities/bonds respectively would have an expected result over long periods of time of 7 to 8 percent.
Granted, the differences between the two portfolios described above in the hypothetical example are not large at first glance. We don't have the space here to fully explore the benefits of earning an extra 1 to 2 percent over time, but they are not inconsequential, when considering the effects of inflation and the eventual use of the investment portfolio to provide cash-flow for living expenses in retirement.
So, I would say the 100 minus your age concept for determining a basic breakdown between equities, or other risk assets, and bonds is a good starting point at the conservative end of the spectrum. You then can begin to explore, using some simple math, how much additional risk you may be willing to take. Factors to consider include your personal reaction to adverse market events (Are you driven to sell by the emotion created by price declines?) and your sources of income (which allow you to postpone or avoid using the investment portfolio for income).
If there is one benefit to the 2000 to 2002 and 2008 to 2009 bear markets which decimated most risk-based asset categories, it is that we now have a fresh reminder and data to use in our assumptions of the possibility for bad things to happen. For example, prior to the last decade, the worst stock market decline of the previous two decades was about 30 percent. But, in the last 10 years we have had two reminders that stock prices can be cut in half or more, with particular markets segments suffering even larger declines.
So, when assuming that a certain percentage of your portfolio in stocks and other risk assets will be OK, I suggest going through a worst case scenario like this. If you have 60 percent of your portfolio in assets which decline 50 percent, the impact on your overall portfolio just from that portion will be a 30-percent decline in the overall value. The 40 percent of the portfolio which is in the safer assets may provide some buffer through price appreciation during one of these stressful market events, but there is still a good chance for a 20 plus decline in overall portfolio value.
The next step in this assessment is to personalize the decline, say 25 percent, for your portfolio. Most humans think in dollars vs. percentages, so take the value of your investment portfolio and subtract the 25 percent from its value. How would receiving an account statement with that value make you feel? If it would likely invoke an emotionally driven decision, then perhaps you should consider a more conservative portfolio with less in the risk portion.
This is not the easiest process in the world because imagining the decline is not the same as experience the decline. The solution is to default to the more conservative side of the decision. One lesson we have learned through the years is that a conservative approach which avoids emotionally driven decision making is probably going to yield a better result than a more aggressive one that leads to mistakes through the powerful tug of panic and fear driven decisions.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.