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When to Go Against Your Gutby Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc.August 26, 2008 Reprinted from the August 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients. "Follow your instincts" may be wise counsel for many of life's situations. But doing so when investing may actually steer you in the absolutely wrong direction! As the old saw goes, the market is driven by fear and greed. But too much of either instinct can lead to portfolio decisions that are harmful to long-term wealth creation. In fact, in recent years an entire field of study dedicated to behavioral finance—or how individuals act, react and follow their instincts—has emerged. Here, we'll examine three common investor situations when going against your gut is exactly the right thing to do. Don't get confused by the news Are you feeling glum because of a barrage of troubling economic, geopolitical and market headlines like the ones below? Well, you're not alone. In June, the University of Michigan's Consumer Sentiment Index was 56.4, the lowest since it fell to 51.7 in May 1980.  What you may not have realized at first glance is that these seemingly recent headlines are, in fact, not so recent. Actually, they're all from September, October and November of 1990, when the first President Bush was in the White House. That was a year when nearly all markets and asset classes experienced negative returns. However, if the bad headlines, the follow-the-crowd sentiment and the nervous feeling in your stomach led you to become more conservative or get out of the market altogether, you would have regretted it. The next year began an eight-year bull market that saw stocks rise 354%! So, when ugly headlines give you the urge to pull out of the market or get more conservative, remember that the media is often a lagging indicator. Short-term (less than a year) movements in stock prices are often driven more by changes in expectations than by fundamentals. And by moving rashly, you may do harm to your portfolio. For example, if you'd invested $1,000 at the start of 1990 but pulled out during the market trough (October 31, 1990), only to reenter four months later, you'd have had 20% less at the end of 1991 than if you'd stayed invested in the market the entire time.2 Don't chase performance Let's say you're ready to add a new investment to your portfolio. You find one with stellar recent returns, and your gut tells you to snap it up? Best to look before you leap.  Consider two hypothetical investments, labeled Peach and Pear in "Consider Your Options." If you looked at 2007 returns, which would you select? Pear outperformed Peach by over 12 percentage points. Pear's one-year return, though negative, is 8.5 percentage points higher than Peach's. Pear's three-year return is 9.1 percentage points higher than Peach's. Does instinct tell you to go for Pear? Not so fast. What if I told you their 38-year returns are nearly equal? Well, Peach and Pear represent real indexes: Peach, U.S. small-cap index, and Pear, international large-cap index3—both of which have been buoyed in recent years by strong global growth and a weak dollar. Perhaps not surprisingly, investors have been throwing money at the top performer. In 2007, $68 billion flowed into Morningstar's three foreign large-cap categories, while $14 billion flowed out of the three domestic small-cap categories. In a recent review of client portfolios, we found many to be overweight in international stocks and underweight in small-caps. Worse yet, many clients have been asking if they should add more top-performing international stocks. Our answer: No! History shows that asset classes tend to revert to their long-term average returns over time, and chasing performance can be a dangerous strategy. Following your gut and buying the top performer (in this case, international large-cap stocks) means you're more likely to buy high and take unneeded risk in your portfolio. If you're in this situation, steel your stomach and consider lightening up on your international equity holdings while bringing your small-cap allocation up to your long-term target level. Don't forget to rebalance Rebalancing your portfolio—buying or selling assets to restore your portfolio's original target allocation—can be really hard to do. After all, it requires you to sell assets that have performed well and buy those that haven't—just what your natural instincts probably tell you not to do. But ignoring your gut and rebalancing are keys to controlling portfolio volatility and building wealth. As you can see in Asset Classes Move In and Out of Favor, returns can vary from year to year. When an asset class is performing extremely well (see large-cap value in 1995, small-cap value in 2000 or emerging markets in 2003), rebalancing feels wrong. Indeed, when equities were on fire in the late 1990s, large numbers of investors fell in love with stocks and didn't rebalance. So they ended up with a larger percentage of stocks in their portfolios than their risk levels warranted—due to market actions alone. Many even bulked up on already overweighted technology positions, assuming the robust performance would continue. Of course, when the market started to fall in 2000, tech-heavy investors were pounded—more than they likely expected, and more than if they'd rebalanced. Many investors are repeating that mistake now, letting their portfolios become overweighted with recent top performers such as commodities and foreign stocks, particularly in emerging markets. But today's winners can quickly become tomorrow's losers, exposing you to undue risk. Rebalancing a moderately conservative portfolio annually from 1993 to 2002 would have earned you a slightly higher return than doing nothing—7.8% versus 7.4% per year. But with the unbalanced portfolio, you would have taken on 26% more risk (as measured by standard deviation, a common measure of volatility). From August 2000 to September 2002, you'd have experienced a 17% drop in the value of your portfolio, versus only an 8% drop if you'd rebalanced annually. If you needed to sell during the downswings, you might have been in dire straits. Plus, with higher volatility, it's easier to panic and move in and out of the market—often at just the wrong times. So how often should you rebalance? We recommend taking a look at your portfolio at least once a year and thinking about pruning any asset class that's overgrown its target by more than 5%. Fighting your worst nature What are the best ways to avoid investors' worst natural instincts?
Important Disclosures 1. All headlines are from The New York Times. Dates of headlines: (1) September 5, 1990; (2) September 6, 1990; (3) September 9, 1990; (4) September 17, 1990; (5) October 17, 1990; (6) November 21, 1990; (7) November 16, 1990; (8) October 21, 1990. 2. Over the four months that the hypothetical investor was out of the market (November 1990 through February 1991), three-month U.S. Treasury bills (represented by the Citigroup three-month Treasury Bill Index) returned 2.3% while the S&P 500® returned 22.4%. 3. Peach is represented by the Russell 2000 Index® since 1979 and the Center for Research in Security Prices (CRSP) Cap-Based Portfolios 6–8 (representing the New York Stock Exchange, AMEX and Nasdaq stocks ranked in the sixth through eighth deciles by market capitalization) prior to 1979; Pear is represented by the Morgan Stanley Capital International EAFE (Europe, Australasia and Far East) Index. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. International investments are subject to additional risks, such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks. Small-cap stocks have historically been more volatile than the stocks of larger, more established companies. Diversification and asset allocation strategies do not assure a profit and do not protect against losses in declining markets. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Examples included are hypothetical, provided for illustrative purposes only and not intended to be predictive of future results. Data contained here from third-party resources is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. (0808-4245) Return to Top |
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