You might think that buy-and-hold will get you past this crisis, too. But the message of the market has never been purely buy-and-hold. The right strategy is buy, rebalance and hold. Rebalancing is one of the principal ways of capturing profits and reducing risk. It’s especially suited to frightened markets like these, when no one knows whether to throw money in or run and hide.
Rebalancers engage in what’s known as “target” or “program” investing. You set a target for how your money should be divided among stocks and bonds—for example, 60 percent stocks, 40 percent bonds. If the stock market rises so much that your stocks are now valued at 65 percent of your assets, you sell off the extra 5 percent and reinvest it in bonds. That brings you back to your 60-40 split.
It’s hard, emotionally, to sell an investment that’s going up. “Dumb,” your gut would say. But wouldn’t you like to have taken some profits in July, before the market slid 9 percent? Target investors don’t consult their gut or their guru when making a move. They just follow the program, selling high and buying low. When do you rebalance? Any time one of your asset types—U.S. stocks, international stocks, bonds and so on—grows to 5 percent more than your target allocation, or falls 5 percent below it. Like now.
Being a target player implies that you diversify your investments. For stocks, that means owning at least a broad-based U.S. fund and an international fund. Some advisers tell you to forget it—global markets are now so closely tied that their stocks rise and fall virtually in tandem. You might as well own U.S. stocks alone.
Wrong, says Meir Statman, finance professor at Santa Clara University in California. Diversification works even in markets that move together because they rise or fall at different rates. The U.S. and international indexes are a good example. The current estimated difference between their returns averages 6.6 percent a year. “That’s a big number,” Statman says. You can’t predict which of these markets will earn more (or lose less), so you own both.
For more evidence of the value of diversification, look at what’s happened since January 2000, when the tech bubble burst. Standard & Poor’s average of 500 leading stocks has risen just 1.63 percent a year, with dividends reinvested, Morningstar’s Mark Komissarouk reports. (Remember when everyone expected 15 percent?) A diversified portfolio of 60 percent U.S. stocks and 40 percent bonds yielded 3.7 percent. A 50-50 mix of U.S. and international stocks yielded 7.86 percent.
It’s probably enough to hold 30 percent of your stock investment in internationals, with 70 percent in the United States. Nearly half of the S&P companies have major sources of earnings abroad, so, combined, you’re probably 50 percent invested in foreign growth. The market has hammered real-estate investment trusts—down 10.7 percent over the past three months. Emerging markets are off 4 percent since the end of July. Both could drop further. Still, under the buy-low rule, they’re worth looking at. A reasonable allocation would be 5 percent to each.
High-quality bond funds behaved the way they’re supposed to. They protected that portion of your money that you’ll rely on for future income. Safe Treasury funds rose. Tax exempts lost just a tad.
The easiest way to set targets and rebalance is by owning index mutual funds that track the markets you want. For brokerage customers, there are exchange-
traded funds that track these markets, too.
All of this raises the question—does the credit squeeze in housing point to a recession ahead? The consensus says probably not. Consumer spending will slow as fewer families are able to tap home equity for cash, but it won’t collapse, says Diane Swonk, chief economist for Mesirow Financial. Unemployment may rise a bit. But global growth remains strong, the service sector is healthy, manufacturing is improving, core inflation has dropped and businesses have plenty of cash. “There can be pain in the credit markets with no serious damage to the fundamental economy, as long as the pain doesn’t persist,” says Lakshman Achuthan, managing director of the Economic Cycle Research Institute.
But although the first taste of financial crisis may not be followed by recession right away, the seeds are being sown, says Allen Sinai, chief global economist for Decision Economics. Always diversified, Sinai holds U.S. stocks (although he wouldn’t touch housing stocks yet). For new money, he prefers Asia and the euro zone. “This isn’t America’s decade,” he says.
Stocks up or stocks down, target investors always have a plan. Rebalance now. If you have to do it again at lower prices, so be it. That’s a formula that works.
