Wednesday, November 27, 2013

Now is the Time to Consider Lowering Your Portfolio Risk

During the 2008/2009 stock market crash, it wasn’t too hard to find people telling you to re-evaluate your asset allocation and tolerance for risk. However, that was a terrible time to lower you portfolio risk; now is a much better time to consider this question.

It’s natural for your emotions to tell you to sell stocks after they’ve dropped and to buy more after stock prices rise. To a certain extent it is these emotions that drive stock market swings. However, it’s not too hard to see that this behaviour amounts to selling low and buying high, which is exactly the opposite of what most investors want.

Re-evaluating your asset allocation isn’t necessarily a bad idea, but there are wrong times to do it. The stock market lows of March 2009 were the wrong time to consider selling stocks. Even if you were right in deciding that your stock allocation was too high for your risk tolerance, making a change back then would have caused a permanent loss of capital.

Now would be a great time to consider lowering your stock allocation. Stocks have risen tremendously from their lows four and a half years ago. If you suffered through the stock market crash and doubt that you could handle it again, lowering your stock allocation now would not cause a serious permanent loss of capital.

I’m not saying that investors should sell stocks now. I’m just saying that if you must sell stocks, now is a far better time to do so than 2009 was.

We can flip this argument on its head as well. If you are considering increasing your allocation to stocks, the recent big run-up in stock prices makes now a bad time. 2009 would have been a much better time to decide to buy more stocks.

Most of the time the best thing to do is to stick with a sensible long-term plan. However, if you’re determined to change your allocation, the best time to do it is usually when your emotions are pushing you in the opposite direction.

11 comments:

  1. Now probably is a very good time to do at least a partial re-balance if someone can no longer contribute additional money to their portfolio. e.g. during the retirement drawdown years. The markets have climbed so substantially this year while fixed income has stayed so flat, a lot of asset allocations must be getting out of whack.

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    1. @Bet Crooks: Rebalancing to stay consistent with a long-term plan is sensible at any time. However, if you're considering a permanent change to your stock allocation target, you should avoid lowering it after stocks have dropped significantly or raising it after stocks have risen significantly.

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  2. I am planning to semi-retire in 3 years. Currently I am at 85% stocks, 15% bonds. Since I have moved to Canada I can no longer contribute to my 401K in the US. Do you think it would be prudent to move more money into bonds at this point? I am contributing to an RRSP through my employer, in a 60/40 balanced fund but this is not going to amount to more than $28-$29,000 by the time I retire.

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    1. @Tara C: I would need quite a bit more information to give a specific answer to your question. In addition, I don't do this professionally. I can only tell you what I do with my own money. I wouldn't have any money I think I'll need within 3-5 years in stocks. If your 15% allocation to bonds is short-term bonds and represents 5 years worth of money you'll need to top off your income after semi-retiring, then you're on the safer side of this rule. You need to take into account any other factors in your life that may result in a need for money.

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  3. Thanks - yes, my cash funds and 15% bond position does cover 5 years of expenses. Right now the bonds are treasury bonds (Fidelity government bond fund, not specifically short term though). I have no debts and no large looming expenses (big ticket items have already been taken care of, I have no kids, parents are very financially secure). Given this scenario, does it sound like I should stay the course?

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    1. @Tara C: Long-term bonds generally earn a higher return than short-term bonds, but at the expense of higher volatility. If interest rates start rising more than expected, some of your safe 5 years worth of expenses may evaporate.

      I have no fixed retirement date set for myself and I choose to be 100% in stocks. If you were to go to a typical financial advisor, he or she would probably put you in balanced funds (50/50 between stocks and bonds). There is no crystal ball that says which approach will work out better. You'll have to decide for yourself what approach you want to take.

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    2. So, you wouldn't have money you needed in 5 years in stocks, and you think money in bonds could evaporate, so that appears to leave 5 years of cash reserves as the only other option. Hmm, okay. I have been 100% stocks up until about 9 months ago, when I figured I should have a bit more reserves in the event of another crash. During the last crash, treasury bonds held up very well. I was not focusing much on interest rate increases. Maybe I will move the bonds into cash and forget the bond category altogether.

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    3. @Tara C: My crystal ball is always cloudy. So, I won't make any predictions about bonds, interest rates, or anything else. I try to focus on volatility. If you want 5 years of living expenses to be safe, you need to choose some sort of cash equivalent or short-term bonds.

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  4. "Now would be a great time to consider lowering your stock allocation."

    Very prudent, certainly if you could not handle your portfolio value dip by 10-20% or more.

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  5. My personal rule is to try to change my allocation when market history, relative expected returns and my personal circumstances suggest I should. Right now it seems a long period of superior bond returns cannot continue, so stocks offer better chances of better returns over a 10-15 year time horizon. Downward volatility, like 10-20% declines, over shorter periods is not my focus, though that is sure to happen to stocks perhaps multiple times. Since my personal circumstances are turning to an income-producing orientation, I quite like the steady and relatively high income stream from stocks, which over the years rises in a broad stock ETF like XIU (2.85% yield at the moment) vs a bond ETF like XBB whose yield to maturity is only 2.65%.

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    1. @CanadianInvestor: I tend to doubt my ability to make such judgments, but in this case it's hard to see how bonds could perform well. It seems impossible for interest rates to go below zero. The only possibilities seem to be either rising interest rates or stable interest rates. The first hurts bonds and the second is neutral.

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