Investors don't have a crystal ball. But if you want to be successful, using a fixed asset allocation and periodic rebalancing can boost returns while saving you time and worry.
I’m often asked what I think the market is going to do in the next month, quarter, year or even decade. I usually reply, “I don’t know and I don’t care.”
While that’s not entirely true — because I do care at least a little what happens to my investments over the next 10 years — I certainly don’t know what will happen to them. I learned very early in my investment career that I have no idea what the stock market, interest rates or exchange rates were going to do in the future. It also became very clear to me that experts, analysts, economists and even “gurus” also had no idea. In many cases their guesses were worse than flipping a coin or, to borrow a phrase from Burton Malkiel, worse than having a monkey throw darts at the stock page of The Wall Street Journal.
I needed an investment strategy that didn’t require me to have a working crystal ball to be successful. After some research, it became obvious that the best of these strategies was to select a reasonable fixed asset allocation of primarily low-cost index funds and rebalance it periodically.
Doctors now in retirement can be excused for not being familiar with the investing literature that clearly demonstrates the superiority of using index mutual funds over actively managed funds. For everyone else, there’s no excuse.
Retail index funds have been available for the last 38 years, since Vanguard instituted its 500 fund, which sought to merely track the returns of the S&P 500 at very low cost. At first derided as mediocre, or even communist, it became apparent by the late 1990s that even though an indexer couldn’t beat the market, he could beat nearly everyone trying to beat the market without any work (or expense) at all.
It turns out that active management (i.e. timing the market and trying to select stocks and bonds that will outperform the market as a whole) is nearly impossible over the long term once you take into account the additional expenses and taxes incurred in the effort.
Over the last 10 to 20 years index and other passively managed mutual funds (including exchange traded funds) have been instituted in nearly every asset class imaginable from emerging market stocks to intermediate corporate bonds. Using index funds eliminates the need to predict which stocks and bonds will do well in the future. When you buy all of them, you will own every winning stock out there and have maximum diversification. Critics argue that you’ll also own every losing stock, but even a cursory glance at the data shows that active management isn’t the solution to that problem.
Fixed asset allocation
An investor can invest in dozens of different asset classes and is constantly faced with the dilemma of determining which one is likely to outperform this year, or even this decade. Again, an attitude of “I don’t know and I don’t care” can be beneficial.
The secret is to buy a combination of three to 10 different asset classes, such as U.S. stocks, international stocks, inflation-protected bonds, cash or even precious metals. Any reasonable combination is likely to do fine over the long term. You’re looking for the lowest possible correlation between the various asset classes, so that in any economic situation, something you own is doing well. Likewise, if you’re truly diversified, one of your asset classes is usually doing poorly.
An investor might choose this asset allocation:
• 20% U.S. large stocks
• 10% U.S. small stocks
• 20% international stocks
• 15% corporate bonds
• 15% inflation-indexed treasuries (TIPS)
• 10% cash
• 10% gold
In good times, the stocks will outperform. In a recession, the bonds and cash will do well. In times of high inflation, the TIPS and gold would be expected to do well.
I recommend an investor actually write down his investing plan and asset allocation in an “Investing Policy Statement.” Once a year, he can pull out the statement and remind himself of why he chose his particular asset allocation. That is also a great time to rebalance the portfolio.
If U.S. stocks have been on a tear, he can sell some of that asset class and buy what has been doing poorly, such as cash or gold. In a year like 2008, he likely would have found himself selling bonds and buying stocks. This method ensures that the investor is always buying low and selling high, but, more importantly, he is maintaining the desired level of risk in his portfolio.
Move on with life
An investor who adopts a “know-nothing” portfolio composed of a fixed asset allocation of index funds gains many benefits in his life. He gets a portfolio that is likely to perform just as well, or even better, than that of many professionals. He has eliminated the need to waste time tracking the market or reading financial news. He no longer needs to spend more than a few minutes a year managing his portfolio.
Since the method is so simple, he may also find he doesn’t need to spend thousands of dollars each year on an investment manager to implement his portfolio, further boosting his returns.
An investor who invests in this manner also eliminates the emotion from his investing. Many studies have demonstrated that an investor can be his own worst enemy. The constant cycle between greed and fear can cause many investors to repeatedly buy high and sell low, a losing strategy if there ever was one. Following a simple, written, mechanical plan minimizes emotional and behavioral investing mistakes.
Most importantly, the investor gets his life back. He doesn’t have to spend time managing investments or worrying about them. He can spend that time helping people and generating more income in his medical practice, spending time with his family, or enjoying outside interests. It can be immensely liberating to realize that while your crystal ball is cloudy, so is everybody else’s.
James M. Dahle MD, FACEP, blogs at The White Coat Investor, where he tries to give those who wear the white coat a “fair shake” on Wall Street. He is not a licensed attorney, accountant or financial advisor and you should consult with your advisors prior to acting on any information you read here.