Written by Lance Roberts, Clarity Financial
— this post authored by John Coumarianos
The S&P 500 Index just closed down 3.69% for the month of February. That’s not a shockingly bad monthly return, and the index was still up 1.83% for the year at the end of the month. But February was the first time the index posted a monthly decline after 15 straight months of gains – a previously unmatched stretch of such consistency.
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And that has investors gripped with two contradictory and emotionally exhausting fears – 1. The market’s powerful multi-year run may be coming to an end. 2. Selling stocks might result in missing more gains. In this vein, The Wall Street Journal reported today on investors who have manipulated their allocations in radical ways in response to the market’s moves and their own fears. For example, Justin Beghly from Arkansas, sold all his stocks early in 2017 in response to President Trump’s election victory, only to buy them back later and white-knuckle it through the February decline.
What’s remarkable is that none of the investors interviewed – including those who had advisors presumably keeping them in steady allocations – talked about how much of their assets they had in stocks. It was as if their choices were 100% stocks or 0% stocks. In other words, their main question was: Should I be in or out? Similarly, I was speaking to an investor two weeks ago, who had all her stocks in one account and all her bonds in another account. Her overall allocation was roughly balanced, but all she could think and talk about were her stocks. It was as if the bonds didn’t exist.
Investors must undergo many changes before they stop buying high and selling low, but two of those changes must be to understand how much of their assets are in stocks; and to stop concentrating on their stocks alone. Another crucial change investors must make is to think longer-term. That’s because if the choice is between stocks and bonds, it’s much easier to estimate future long-term returns than future short-term returns.
As my colleague, Michael Lebowitz, argued recently, most of the time, answering the question of whether to own stocks or bonds isn’t easy. The answer depends on an investor’s time horizon, tolerance of volatility, and other things. And most investors should have enough stocks to feel as if they are participating in the market when it’s rising, and not destroying their portfolios when it’s declining. That’s not an easy balance to strike, but it’s the crucial work that investors must do either by themselves or with their advisors.
Now Michael says this time it’s easier than other times to exclude stocks because U.S. stocks are so overpriced that they may not beat bonds over the next decade. It’s very difficult for stocks to post robust returns from a starting Shiller PE (current price relative to the past decade’s worth of real, average earnings) of above 30.
I am sympathetic to Michael’s argument, and I am also reminded of Ben Graham’s definition of the “enterprising investor” in his book The Intelligent Investor. Graham distinguished between someone who maintained a steady balanced allocation – a “defensive” investor – and someone who studied the markets hard, and manipulated his allocation accordingly – the “enterprising” investor. Graham thought the enterprising investor mush put in great effort to warrant the allocation manipulation he did. Graham also thought most enterprising investors should operate portfolios whose stock exposure landed between 75% and 25%.
(Importantly, this is the method all models at our firm are managed as equity exposure, as noted in the 401k Plan Manager below, is ratcheted up, and down, in 25% increments with equity never falling below 25% of target allocations.)
In other words, 100% and 0% were too extreme for Graham to recommend even to a savvy student of the markets. If you own no stocks, and the market keeps racing, you may foolishly buy some stocks at higher and higher prices. Better to own some now at admittedly high prices, because that might prevent you from buying at still higher prices. Also, better to peak at 75% stock exposure on the way down. That’s because if the market keeps declining after you get to 75%, at least not all of your money is exposed to falling prices.
Ordinary investors today, fret about being fully exposed or not exposed at all to stocks, when one of the greatest students of the markets and investing counseled only the most sophisticated investors to toggle between 75% and 25% stock exposure. Most others should stick to a static allocation, which, of course, means rebalancing from time to time. And rebalancing means selling stocks gently as they’re going up, and buying them gently as they’re going down. The first step to being an intelligent investor is to lose the all-in or all-out mindset.
