If you were invested over the past year, it is highly likely that your portfolio is in good shape. Following the sharp declines from the onset of the pandemic, the equity markets have been on a breathtaking tear. Now what? Are you tempted to at least partially bail on equities and move to the safety of cash? You wouldn’t be alone.
I’ve come to dislike the way-overused terms “frothy” and “lofty” so I’ll go with “overvalued.” Many market analysts, and television talking heads, are advising investors to lighten up on stocks because they believe the equity markets are, indeed, overvalued. Although I can make convincing arguments to either support or contradict this premise, I’m not going to waste your time by doing so, as my opinion on the direction of equities is irrelevant. Rather than add to the noise, I’ll discuss my approach to navigating unsettling markets (as most of us find pretty much all markets to be unsettling). My recommendation is that you create an appropriate asset allocation for your portfolio, rebalance it when necessary, and try to sit tight and ignore the plethora of market prognostications. This is easier advice to follow in rising markets than when the markets are heading south — a true test of one’s financial fortitude.
By “an appropriate asset allocation” I mean one that thoughtfully balances risk and reward relative to your circumstances, not just an age-based “rule of thumb” asset allocation. Besides age, your asset allocation should consider both objective and subjective factors such as: time horizon (when will you need to draw down funds, and for how long); your risk tolerance (over time, not just in the moment) your prior experience investing in various asset classes (investing in the unfamiliar is a prescription for anxiety); your current and anticipated lifestyle (expenses and other portfolio outflows); your non-portfolio sources of income; and your ability to replace lost capital. Whether or not you work with a professional financial planner, I recommend that you educate yourself on the tenets of financial planning and investing; there are many written and online resources to address every level of financial sophistication.
Once you decide on your asset allocation, you should not “set it and forget it;” investing for your future is not a spectator sport. As asset classes within your portfolio rarely rise and fall proportionally, you’ll need to periodically “rebalance” your portfolio back to its target allocation. Rebalancing can be quite challenging as it requires selling off equities when they are rising, and even more so, buying equities when they are declining. Professionals have differing opinions as to how often one should rebalance. I recommend a thorough portfolio review and rebalancing to your target at least quarterly. I also recommend rebalancing back to your target asset allocation when an asset class is more than 5% off its target. I disagree with those who rebalance following smaller market moves as frequent trades can run up your tax bill.
Although I don’t recommend modifying your target asset allocation based on market prognostications, it also should not be viewed as completely stagnant. Most of the inputs going into the construction of one’s asset allocation tend not to vary much over short periods of time, but sometimes they do. You should consider modifying your asset allocation to reflect longer term changes in your lifestyle such as retirement, relocation, changes in your family’s structure, and modifications of your life objectives.
In March of last year, as equities were tanking following the onset of the coronavirus, I expressed my commitment to asset allocation in my “Rob to Riches” column in Forbes Magazine: “Coronavirus and the Markets: What Do We Really Know?”
“Adjusting one’s portfolio to rebalance into asset classes that have declined is smart. Adjusting one’s asset allocation to reflect changes in long-term financial objectives, and evolving risk tolerances, always is appropriate. Going into cash out of fear, with the intention of coming back into equities at better valuations isn’t a strategy – it’s the definition of market timing, which rarely works out well.”
Going back to my initial question on the temptation to sell equities because of (real or perceived) concerns over market valuations, you may believe that reducing your exposure to equities is the tough decision. It isn’t. Going to cash, especially to lock in gains, is relatively easy, even if at a significant tax cost. The tougher, and much more complicated decision, is: “when do I reenter the equity markets?” Unless you want to change your long-term asset allocation, going to cash is a temporary decision. Before doing so, you need to ask yourself: What does reentry look like? Generally, the quick answer is: “at more reasonable valuations.” Based on my experience with clients going to cash, and intending to eventually go back into equities, rarely does any reentry point seem comfortable. Should equities continue to rise, even after a slight pullback, you may find it difficult to reinvest at a higher price point. Doing so can feel foolish for obvious reasons, including the very real fear of prices subsequently falling after you reinvest (your initial motivation for selling) and then getting whipsawed. Alternatively, should prices fall from where you sold, you’ll feel smart, but then may be asking yourself if they’ve fallen enough for you to be comfortable with their lower valuations, and to offset the tax cost of having sold – think about the adage of catching the proverbial falling knife. Both outcomes challenge our cognitive biases.
Will there be the significant market correction that many of the talking heads are predicting? You can count on it, and it will be extremely unnerving when it does occur. Although a market selloff will be painful, the markets will come back – eventually. And when they do, you’ll be happy that you remained invested.
The author does not provide tax, legal, financial or investment advice. This material has been prepared for informational purposes only. You should consult your own tax, legal, financial and investment advisors before engaging in any transaction.