Yahoo Finance How Investors Can Win By Finishing in the Middle
Most people would prefer to win, rather than finish in the middle of the pack.
But when it comes to investing, winning takes on a different meaning. Many financial advisors suggest that people emulate the slow-and-steady tortoise, rather than the hare, who boasts about his speed.
In that context, the hare tries to pick winning stocks or funds, then bails out when the investment doesn't perform as expected.
The tortoise sticks to a broadly diversified portfolio and doesn't get distracted by ever-changing market conditions or a tip about some hot, new idea.
Over time, staying the course results in a better outcome than constantly trying to pick winners and losers. Dalbar, a Boston firm that researches individual investors' performance, has shown that the average mutual fund investor tends to buy high and sell low, underperforming basic indexes such as the Standard & Poor's 500 index or the Barclays U.S. Aggregate index of bonds.
Even so, advisors say, it's not enough to simply invest in funds tracking those two indexes. A 2012 research paper from the Vanguard Group showed that U.S. investors have some rational justification for a "home bias," or a tilt toward domestic stocks. However, only holding an S&P 500 index fund puts an investor at risk in years when large-cap domestic stocks underperform other equity asset classes, including emerging markets or U.S. small caps.
A properly allocated portfolio consists of the various asset classes of stocks, bonds and alternatives, such as real estate investment trusts or managed futures.
But they're not thrown together willy-nilly. An investor must determine the amount of each asset class to hold based on his or her risk tolerance and financial objectives. The portfolio should generate the return needed for a goal, like retirement, without taking so much risk that the investor can't sleep at night, terrified of losing everything in the next downturn.
That's not the same as simple diversification, explains Steve Wruble, chief investment officer at RiskX Investments in Omaha, Nebraska. "Asset allocation is a strategy that is often used in the pursuit of diversification and involves employing the tools at your disposal in the pursuit of a desired portfolio outcome," he says. "Diversification is, conceptually at least, nearly the opposite. Diversifying could mean adding another investment strategy as a way to lower the risk of being incorrect because of uncertainty."
Asset allocation is a scientific approach that relies on data to determine the correct asset classes to hold and in what amounts. This strategy does not eliminate risk, and it doesn't mean investors won't experience losses in a poor market. "An allocation strategy is designed for more manageable returns in down markets, and it is designed for achieving a portfolio goal," Wruble says.
For example, in 2008, a portfolio of 65 percent globally diversified stocks and 35 percent short-term, high-quality bonds would have declined around 25 percent. However, that's less than the decline of an all-stock portfolio that year. The diversified portfolio had less ground to make up in the subsequent years as equity markets rallied.
In addition, allocated investors weren't making bets or tinkering with holdings based on news reports or personal opinions. In late 2012, financial TV anchors were breathlessly proclaiming that the so-called fiscal cliff crisis would cause U.S. stock markets to plunge into the abyss. Congress ultimately made a deal to avert the crisis, and the S&P 500 finished 2013 with a total return of 32.39 percent. Many investors who panicked and sold their U.S. stocks missed that gain, even as a portion of an allocated portfolio.
Contrary to its nickname, "the benchmark index," the S&P 500 is not the gauge for an allocated portfolio. That can be difficult for U.S. investors to grasp, since news reports often highlight its performance to the exclusion of other asset classes, such as international or small-cap stocks, or bonds and alternatives.
The idea of strategic asset allocation is to smooth returns, eliminating the risk of too much exposure to one asset class, such as large-cap U.S. stocks, which make up the S&P 500. Proper allocation is achieved using passively managed funds or index funds. There's no stock-picking or market-timing involved, and portfolios are regularly rebalanced to bring each holding back to its predetermined target weight.
But for investors who have been trained by the financial media or financial services industry that beating the S&P 500 is their goal, asset allocation may seem like settling for mediocrity.
That's not the case, says Deanne Rosso, a wealth advisor at Vickery Financial Services in Athens, Georgia. "Asset allocation means always owning the winners," she says. "No one can predict which asset class will be the best performer in any given time frame, so the best way to ensure that you own the best performer is to diversify among many asset classes."
For that reason, it's crucial to stay invested and avoid timing buys and sells in an attempt to capture more gains or mitigate losses. The example of the S&P 500's return in 2013, following predictions for utter catastrophe, serves as a cautionary tale. Market history shows there's no reliable way of forecasting which asset class will lead or lag at any time.
"Changes in the stock market often happen in short, rapid time frames, and that can lead to investors missing some of the best days in market performance because they were trying to avoid the worst days. Markets appreciate over time, and we believe investors have better success by managing through market conditions, not trying to time the market," Rosso says.
Jeff Teach, founder of Teach Wealth Management in Palm City, Florida, says investors are well advised to ignore friends who boast about their returns in any particular stock or fund. "The science of investing has proven that being passive in nature, not trying to time the market and not worrying about what your friends are doing will give the investor more peace of mind," he says. "What you hear from your friends is not something any smart investor should pay any attention to. Are they experts in the art of investing? I don't think so."
Teach, whose investment philosophy is based on academic research by Nobel Prize winner Eugene Fama and others, says investors must think globally and understand the role of asset classes other than stocks. He points out that in most cases, a properly allocated portfolio should contain bonds, even though they don't appreciate at the same rate as stocks.
"Investors need to be educated as to what bonds should be used for," he says. "We use bonds to control the risk in the investor's portfolio, not to get income or to add risk. If you are an aggressive investor, then maybe you don't want any bonds. If you're a conservative investor, you need a certain portion of your portfolio allocated into short-term, high-grade bonds. Eugene Fama has proven that investing in long-term bonds can be just as risky as owning a large-cap stock. Chasing yield and/or buying junk bonds can also be very detrimental to performance."
Wruble says U.S. investors are harmed by the deeply ingrained notion that the S&P 500 should be their performance benchmark. "Here is the problem that we have in this industry: How many advisors support the idea that the S&P 500 is an appropriate benchmark? It's not for most, and especially not a client who utilizes asset allocation as a way to help lower the risk of overexposure to just one asset class," he says.
A blended benchmark -- which tracks the performance of various asset classes, such as domestic and international stocks, small-cap stocks, value stocks and bonds -- is a better tool to gauge returns of a properly diversified and allocated portfolio.
"It's easy to lose perspective when we are bombarded with the S&P and DJIA everywhere we turn," Wruble says. "Consistently in the middle, over a market cycle, would look pretty good to most investors."
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