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Mid-year Portfolio Review
Part 1: Volatility Makes Check-Up Essential
Sometimes, people forget why they invest.
In reality, individuals don't get into the market to brag about outperforming the indexes. "Every investment dollar plays a role in your life," says Jim Guilfoil, Russell National Sales Communication Manager. "What investors really want is to send their kids to college, retire when they want and build a reasonable estate."
But there's a catch. Sometimes investors let up-and-down investment markets skew their long-term vision, impacting their ability to reach goals. Significant performance pops, such as the growth of major equity markets around the world in the first half of 2003, should be just as much of a catalyst to reviewing your investments as a significant performance dip.
Riding the Seesaw
Think of investors who left equities after they have tumbled through the first three years of the decade. Many investors who left are just starting to feel comfortable with stocks again and are now moving back in after a strong run up. But investors who stayed fully invested via a well-diversified portfolio have been able to avoid the market-timing guessing game by holding different asset classes, investment styles and market caps. This way, while one aspect of their portfolio was diminishing, another aspect was reaping the rewards of being able to buy low and ride a growing wave.
In effect, diversified portfolios put savvy investors ahead over the longer term by keeping them in the market. Getting in and out involves a lot of guesswork — and volatility often causes investors to guess wrong.
But you have to understand what diversification is all about. Guilfoil points to the 1990s. "Many investors believed their portfolios were diversified because they owned, say, five mutual funds. But those all tended to be large-cap growth funds." What's wrong with riding a horse that's way out ahead of the pack? "Those funds may have soared for several years, but then they plummeted, and investors who weren't diversified felt a lot more pain."
The problem, according to Guilfoil, is that while investments are performing well, most investors believe they can withstand more risk than they really can. When performance heads south, they bail. Compounding the trouble is that it generally takes a significant pop in the market for them to feel comfortable with risk again. And by that time, it's possible that a great majority of the investments growth will have already occurred.
A Dalbar survey examined US market activity from 1984 to 2000. During that period, the S&P 500 returned an annual average of 16.29%. Yet the average stock fund investor posted returns of only 5.30%. US T-bills actually did better at 5.82%. What happened?
"Investors chased hot funds," Guilfoil asserts. Instead of maintaining a diversified portfolio they often bought right at the peak, then ended up selling at the bottom. "A diversified portfolio can prevent a lot of this," says Guilfoil. "But staying with a diversified strategy takes discipline. That's where asset allocation comes into play."
The "Enforcer"
On the first level, asset allocation designates specific percentages of a portfolio for domestic and international equities, fixed-income, real estate and cash. Russell's strategy of diversification-in-depth goes deeper, allocating each asset to multiple managers using varying investment philosophies among the different value/growth and large-cap/small-cap universes.
But assets need to be reallocated as the market shifts and percentages of varying categories get out of balance with preset goals. Many investors examine their portfolios annually — often in January. That's the maximum time that should go by, according to Guilfoil. Semi-annual or even quarterly reviews are fine, too.
What happens if equities, or, digging deeper, small-cap issues, for example, have moved above or below target? "It's time to shift back," Guilfoil says. Some investors are more comfortable than others with letting their allocations stray by a few percent or more, but the idea is to rebalance to the allocation that was originally established based on your risk tolerance and goals.
Why review your portfolio now? With the 10.6% surge of the S&P/TSX Composite Index in the second quarter of 2003, the equity portion of a portfolio has grown compared to the other asset classes. If it has changed the slices of your portfolio pie too much, it's time to rebalance back to the asset allocation that meets your risk tolerance and needs levels.
How to reallocate? Sell the winners and start buying out-of-favor investments. That may sound strange, but it's not. "Asset allocation forces you to buy asset classes you'd never buy on your own because they're out of favor, which means they tend to be the worst recent performer," Guilfoil emphasizes. On a relative basis, assets within a portfolio can be rebalanced using a 'buy low and sell high' strategy.
"Reallocating makes sense because, historically, asset classes and styles perform cyclically," Guilfoil said. In bear markets, reallocation can help prevent that "sky is falling" attitude that urges investors to bail out — only to return when prices have risen considerably.
Call on a Professional
How can you be certain that you've accurately defined your goals? What's the right way to diversify? And how do you arrive at the proper asset allocation model?
"That's the task of a financial professional," Guilfoil declares. "They provide investors with both objectivity and discipline. They have the ability to help you do what you wouldn't do on your own — for your own good."
If you already have a financial professional, review your portfolio together. By staying in step with a volatile market, where dramatic changes can wreak havoc on the best of plans, you'll be better able to meet your goals.
"Investors can't control the market — but they can always control their reaction to it," Guilfoil said.
In Part 2, we'll examine the process and benefits of choosing a financial professional to help you build a disciplined, diversified investment approach.
This is a publication of our parent, Frank Russell Company. It should not be construed as investment, legal, or tax advice. The contents are intended for general information purposes only, and you are urged to consult your own investment, legal, or tax advisor concerning your own situation and any specific investment questions you may have. For further information about these contents, please contact Russell Investments Canada Limited.
This article was first published on www.russell.com/us on June 26, 2003.
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