Keeping that Balance and Maintaining It: Asset Allocation

Dan Solin is right when he suggests that no one ever brags about their ability to achieve optimum asset allocation. Its not all that sexy and quite frankly, lacks the sexiness that doing something extreme often nets you.  Something like not using asset allocation.

Asset allocation is something of a mystery to most of us although no writer worth her/his mettle would bypass the opportunity to tell you it is one of the keys to investment success.  You will hear those who use index funds as a primary driver in their portfolios selling the notion that once you embrace this passive sort of investment, asset allocation becomes second nature. It certainly becomes easier.

To allocate assets is to take and spread risk across many different stocks and bonds.  The idea here is that no market performs in tandem.  Some corners will remain sluggish while others shoot for the moon.  Asset allocation keeps you in both but keeps you involved in a measured way.

Too much of any asset class usually means that asset is doing really well. This is where the tough part comes in.  If that asset is doing so well, you probably should begin selling some of it in favor of the assets in your portfolio that aren't doing so well. This sounds sort of counterintuitive and I'll explain why it shouldn't.  Even if afterwards, it still does.

Because we are talking mutual funds and not individual stocks, and we will for the sake of the argument, use index funds as an example.  A large cap index fund may be in favor with investors because investors are looking favorably upon the companies in the index. But you also hold an index of small-cap companies that seem to be lagging behind - at least as a comparison. To continue to send money to the ever-rising fund, you should take some of the profit off the table and transfer it to your other allocations, balancing your investments at the point you began.

But, you stammer, that fund could go higher. Why sell a winner? Because that is what you do to make money: sell winners.  But in order to keep your allocation in balance you shift those dollars to the other funds in your portfolio, buying shares in those funds when they are less expensive.

Should you consider using actively managed funds in this process? Depends on your age and whether you plan on focusing on the balance among the funds in your portfolio. If you have a fifteen year or longer time horizon until you estimate you will begin to tap your account for income, feel free to take your chances.

Index fund users will never stop stressing the importance of fees and the low cost index funds have. And this is important.  But fans of the actively traded mutual fund are also focused on fees and equate performance against this measure. But the comparisons are difficult and calling this type of investing successful depends on numerous variables. (From which benchmark is being used to how many funds are spread across how many asset classes, the variables can astound and compound.)

The importance lies in keeping that balance and maintaining it. The only risk you can add to your portfolio is not adjusting your allocations at lest once a year. We are in for a volatile decade, as unemployment strings out, debt continues to be an issue and the tax debates continue and that is not without some pressures in the stock and bond markets.  This balancing act wil take time and effort.  But the person who bothers will end up with more years of positive returns than someone who fails at this decidedly unsexy task.

Stocks Spanked; Mutual Funds Helped

It has been reviewed and reported over and over.  Folks who thought they knew what they were doing in the stock market found out how wrong they could be about not only their investments but their ability to assume risks.

These folks were and many still are, advocates for investment choices.  And many have postponed retirement, blaming not themselves and their unwavering belief that the markets would continue to rise but the markets themselves for not performing as expected.

For example, the CBS Marketwatch report suggests, without saying as much, that had you been in mutual funds and done nothing, you would be close to where you were at the end of 2007.  But if you were in stocks you sold.  And those losses will take a long time recovering.



Sticking with mutual funds that spread the risk over numerous sectors is still the best way to get where you are going.  That and consistent, increasing contributions.

Mutual Funds vs. Stocks: Better, Cheaper, Easier?

Fellow blogger Jenny Decki at BeyondMom asks the following questions:

Why would I invest in a mutual fund?

If I choose five stocks (or 10 or 15) isn’t that (basically) the same thing as being in a mutual fund but without the fees?

I understand that a mutual fund has a manager that watches the stocks within the fund and makes changes as appropriate, but how is that different than day trading? (Other than the fact it’s someone else doing the day trading.)

Jen,

You raise some interesting questions: can you do what a mutual fund does and can you do it cheaply enough to make it worthwhile?

Mutual funds are still both cost effective, tax efficient, and in many cases, a far better investment than wading into the world of stock picking. Yes, mutual funds offer a fund manager(s), a level of research and discipline often not found in the individual investor, and the ability to diversify into a wide variety of stocks. Whereas the individual investor has far more flexibility to sell at moment's notice, some basic problems arise from the effort.

1. Which stocks to buy? While it depends on whom you listen to, the stock market has yet to retain any long-term stability. News, even reports that seem wholly irrelevant to the shares you might own, is still driving the investor to do things they would not normally do during a more stable and predictable market. True, no market offers itself to forecasts, and no stock is immune to industry trends, they can be and should offer some sort of confidence, a belief that the decision they have made is the right one long-term.

2. Which stocks offer long-term stability? Legendary investors always look for value. The average investor looks for gains. The two can be compatible but patience and time are what turns value into profits. Those looking for gains generally do not bring that sort of approach to the effort. Build a sample portfolio at any one of the financial portals and you can test this discipline before you commit real dollars. Keep in mind that these sample portfolios do not usually simulate trading charges or taxes.

3. Are stocks cheaper in the long run? Only in the long run. If you spend a fair amount of time looking at the tickers crawling across the bottom of broadcasts on CNBC for example, the wildly traded moves, the end of session strategies employed by many ETFs (exchange traded funds), and the instant reaction that many of these floor traders have to news (the ability to disseminate what is important right that minute to whatever position they may have taken) is very difficult for the average investor to control. Buying and selling all have costs (to you they are more expensive; to the institutional investor these costs are much lower) and depending on how much you have in your brokerage account, the advertised price many broker offer will be much higher.

4. Are stocks cheaper than mutual funds? Those same legendary investors offer the same legendary advice: fund your retirement, keep your financial house in order and only invest in individual stocks with money you do not need. Benjamin Graham, one of the most legendary of investors coined the term "Mad Money" to describe these accounts. He suggested that you should only put in money you do not need and never replenish those funds (if you win great; if you lose, lesson learned). Investing in stocks, for lack of a better analogy, is gambling. Ask yourself this: if you were at a casino and you had spent all of the cash in your pocket, would ask for a line of credit to continue?

That said, mutual funds still offer you the best way to keep your money working in the markets without taking outsized risks. Keep actively traded funds in your retirement account (the tax deferred opportunity is wasted on index funds in these types of accounts - keep them outside of your retirement account and pay the taxes on the gains and get the tax break on the losses). Be sure to take the time to build an adequate emergency account so you will never touch those retirement investments (these accounts are often referred to as savings - they are not), and if you still have money left over, wade into the ocean of stocks.

As Warren Buffet once said (as legendary an investor as you could quote):"price is what you pay; value is what you get."

The Curious Case of (Index Fund) Fees

There is a simple idea behind the index fund. You create a fund that mimics an index, often published by some other investment company. In doing so, you basically purchase a broad swath of the marketplace, whether it is the top 500 companies, the whole of the marketplace or some other sliced portion of the stock or bond markets. The idea is designed to be cost-effective, in part because once the index is purchased, you basically employ the buy-and-hold strategy until the index itself changes.

So why do the fee vary so widely when it comes to something as simple as an S&P 500 index fund? The answer is they shouldn't. But the truth is, they do. And some are so high, they begin the approach to the fees levied in actively managed funds.

Consider the case (and the motive) for Charles Schwab's recent decision to lower the fees charged to retail investors in their index funds. Any time you lower a fund's fee, it is cause for celebration. Perhaps it is the skeptic in me that asks the question: why were they so high in the first place?

The fee reductions were most noticeable in its two largest index funds. The $4.59 billion Schwab S&P 500 Index Fund (SWPPX) which at one point before the change charged its shareholders 0.19%. Dropping it to 0.9% now positions the fund to take shareholders from the other index funds. But probably not from Vanguard or Fidelity.

Fidelity is selling some of its index funds for 0.1%, while Vanguard Index funds charge around 0.18%. So why care about what Schwab is doing? Low fees are great but to entry level purchases into either of the Fidelity or Vanguard funds can be prohibitive for new investors. Fidelity can charge, in some cases $100,000 minimum investment to get that rate, while Vanguard puts its minimum initial investment at $3,000. Schwab wants only a hundred dollars to open the account.

So should you change for a lesser fee? Yes if the fund is also doing what it intends to do. Numerous index funds drift away from their intended purpose and this error can be costly for investors.

If you are using index funds as they should be (we have often discussed this in our retirement planning blog suggesting that because of the tax efficiency of these funds, it would be somewhat foolish to defer paying the taxes on these types of funds) outside of your defined contribution plan such as 401(k) or IRA, then shopping around and choosing the Schwab alternative might be a very good move.

Sidestepping Risk: Bond Funds Offer More of Less

It is an act of faith to invest. Michel Eyquem de Montaigne (1533–1592), credited with the invention of the essay once suggested "How many things which served us yesterday as articles of faith, are fables for us today" would not be surprised by how investors are looking at their options. No more do investors believe that they can beat the market. No longer do they see risk as something will always play in their favor, rewarding them year over year with riches and gain simply by believing in forces many have no idea about. It seems that they no longer have faith.

We don't need to rehash old news about how far the market has fallen and even as it picks itself up, there are doubts that the once glorious years are well past us. Mutual fund outflows compared to the years prior see a steady rise, enable by the number of people who, for one reason or another think that selling at the bottom (or near bottom) is still far better than taking a long-term approach.

Wall Street and those that report on the happenings there see investor sentiment shift from stocks to bonds and like all good industries, they are moving with the crowd. This is the same crowd who shifted $25.7 billion in assets out of mutual funds in march even as the S&P 500 posted hefty gains. The were undeterred by the fact that there will eventually be a recovery, perhaps, as I mentioned in another post, in as little as four to five years. The folks making the shift have time to wait. But choose instead, to head for the doors.

On the flip side, bond funds gained. The Investment Company Institute, a mutual fund trade group that tracks these sorts of trends noted that the current bond market investment now totals almost $4 trillion, almost a 50% increase over the year earlier (a time when investors still had faith).

Some of that money is headed into target-dated funds, an unproven investment vehicle that promises to gradually shift an investor's money from stocks and bonds to bonds and stocks as they age and become closer to what the fund calls the target. That target, suggested by the fund's name and more importantly, the estimated tolerance of risk as they head toward retirement, has seen net inflows of over $10 billion in the first three months of the year.

This is in part due to the default option in 401(K) plans, where the employer, as directed by the Pension Protection Act of 2006, may invest on the employees behalf in such a fund. And once that happens, studies on investor habits have shown, the employee is not likely to change where their money is headed.

(It has been well-noted here that target-dated funds are an even bigger leap of faith than actively managed stock funds may be, an argument that suggests that these funds are often a mix of bedraggled and failing funds the fund family is keeping alive, albeit in a resuscitative form. Also problematic is the idea that these funds will perform as promised any better than if you had done it yourself, for lesser fees and only an annual revisiting and adjustment of holdings. And one last thing: will the fund manager at the helm be the same one five, ten, or twenty years down the road, perhaps the single biggest factor in the long-term success of the fund?)

There has been an interest in index funds as well. The argument against these in a retirement account is simple: taxes. These funds trade little and because of that lack of activity, their tax implications are very low. If you want to hold an index fund, do so outside of your retirement account where you can still take advantage of the low capital gains taxes. Adding to their attractiveness and your profits in the long=term is the low cost of owning an index fund, which, for the investor means more money in their pocket at the end of the line.

Driven by the need to protect what is invested, even the investment grows at a much slower pace, bind funds have become resurgent. For the younger investor, this type of investment is closer to stashing money under the mattress. For the older investor, it should part of, not the whole of their portfolio. But right now, lack of faith, a downturn in optimism, and the long range outlook focused on short-term results, will drive an increasing number of investors to give up potential gains in favor of not losing.

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We have moved to this blog from our previous location on April 10th. You can find numerous additional articles along with notes from the book "Mutual Funds for the Utterly Confused" (McGraw-Hill, 2008) by clicking here.