Prolonging the Investment Ride

\| DT Online Home \| Site Search \| Personal Finance Advisor \|
	Prolonging the Ride Personal Finance Advisor by Deloitte & Touche OnLine July 13, 1998

After three years of a bull market, many investors feel a little jangled.

Not that anyone’s complaining: who’s griping about the S&P 500 after three years of annual increases north of 20%? Still, good fortune breeds its own litter of considerations. Just as a small business owner must monitor a fledgling firm’s growth, so too an investor should periodically assess even a successful portfolio to ensure it is in keeping with his or her long-term goals and risk tolerance.

In an interview, Thomas Myers, a senior manager and Investment Advisory Services specialist with Deloitte & Touche’s Financial Counseling Services Group, set out to allay concerns and answer some of the questions at the forefront of investors’ minds.

Q: Obviously no one can forecast when or how the ride will end, but should investors be making preparations for a market downturn?

Myers: To focus on what is happening "today" is often counterproductive. Not only can it be a distraction and a waste of time to focus on the short term, but it could do you more harm than good. Numerous studies have proven that your asset allocation is ultimately going to determine the most significant part of your results rather than your security selection and when you get in or out of the market.

Assuming investors have some sort of a diversified asset allocation strategy that they are trying to follow, they should be checking their portfolio regularly -- at least once a year or maybe quarterly -- to see if the market has taken their targeted allocation out of whack. For example, if large-cap stocks have done very well and that segment of their portfolio has grown beyond the 25% to 30% they initially targeted, then they need to make adjustments to bring their portfolio back in line with their targeted allocation. Investment advisers have a term for this ritual -- rebalancing. If you follow that approach of rebalancing, you’ll systematically be selling high and buying low by reclassifying to the asset classes that aren’t doing well.

Q: Easy to say, but that runs contrary to human nature.

Myers: Sure. When things are going this well, who wants to invest conservatively? But investors should not be complacent with risk. The biggest risk of all is that you end up getting into investments or asset classes that are riskier than those that match your risk tolerance and when there is a down turn you’ll sell off at absolutely the worst time, because you weren't prepared for the risks associated with those asset classes.

Q: Are investors hesitant to rebalance because of tax consequences?

Myers: The tax consequences are often minimal, since we're typically talking about making small changes.

Q: Does that mean an investor should always stay the course? Under what circumstances would you advise someone to change their portfolio?

Myers: Changes are typically warranted in two situations -- one, if they didn’t have a plan in place, or two, if their personal circumstances or the objectives they are trying to accomplish change. If they had a portfolio that was setup to meet a specific goal, such as funding education or retirement, and they now have enough money to fund that goal, it might make more sense to move those assets into less risky investments. You have to ask, “have any of the fundamental assumptions or principles changed that made your previous plan sensible or rational?" If so, then you probably need to go back and revisit the plan.

Q: Do the same rules for rebalancing apply if an investor’s funds are in a tax-deferred account?

Myers: Definitely. The same rules apply. In fact, it’s typically a little less painful to do the disciplined thing to the extent these funds are in a tax-deferred account and you can freely make changes without incurring any capital gains tax.

Another thing to keep in mind: It’s probably a good thing to be aware of your most tax-efficient funds. Tax-sensitive investors should keep these outside the tax-deferred accounts and those that have high tax costs should be in your tax-free accounts. For example, funds that have low turnover -- for example, index funds -- you may want to have outside your retirement account, while an equity mutual fund with high turnover would be better inside.

Q: Are you a proponent of dollar cost averaging?

Myers: Absolutely, as a long-term accumulation strategy. One situation where you wouldn't do this is if you have just come into a huge sum of money -- maybe you’ve just sold your business. You should invest it; allocate it and get it in the market. But there’s a psychological case for dollar cost averaging and easing into the market. It takes the element of timing and emotion out of investing. Mathematically and financially there are significant benefits to doing it as well, because you end up getting a lower average cost basis than if you simply averaged the prices on the various purchase dates.

Q: Individual investors aren’t the only ones whose portfolios may be out of kilter. Some mutual funds may also have become unbalanced. How can an investor assess whether a mutual fund is still right for their portfolios?

Myers: Investors have to ask, “Does this fund still give you a representation of a particular asset class? Is it being true to its stated style?” Is the small-cap fund still buying small-cap companies or is a manager drifting up to buying larger companies to boost returns? It may be nice to have the improved returns but that manager is screwing up your plan. Not all parts of your portfolio will be doing well all the time. That's the reality of a diversified investment strategy.

Q: Do you think, because of the market’s dramatic growth over the last three years, that many investors have unrealistic expectations for the future?

Myers: Absolutely. It’s human nature to see a recent trend and expect it to continue. But the market’s long-term historical averages are obviously significantly lower than we have seen in the last three years. Unless you think the world has changed and history is irrelevant, some how some way, it's very likely that we’ll get back in line with those averages.