Admitting Ignorance

“After more than a quarter-century as a professional economist, I have a confession to make: There is a lot I don’t know about the economy.” – N. Gregory Mankiw.

The well-kept secret that the media won’t tell you is that, in spite of the fact that they do it all the time, economists find making predictions fairly tough, and they’re really not very good at them. 

I’ve commented on this before, and past posts are grouped under the Series: The Cloudy Crystal Ball.

If You Have the Answers, Tell Me

In this Sunday’s New York Times column, Harvard professor and economist N. Gregory Mankiw admits with some humility what he doesn’t know.  And he doesn’t know a lot, apparently.  That list includes the very things we care and worry about as consumers, investors, Americans; things such as the future direction of the U.S. economy and unemployment, the future amount and impact of inflation on consumer spending and business investment, and how long the U.S. government will be able to borrow money at such low interest rates.

How refreshing for a professional economist to be humble.

Professor Mankiw’s column is brief and well worth reading.

He concludes with this, “If you find an economist who says he knows the answers, listen carefully, but be skeptical of everything you hear.”

Larry Swedroe has, for many years, expressed similar skepticism about the ability of forecasting to add value.  Mr. Swedroe is director of research for The Buckingham Family of Financial Services, author of several books that I have read with great pleasure, and he is my absolute favorite blogger at Wise Investing.

Never In Doubt, Often Wrong

Here is something he said in 2002.

The track record of economists is dismal (perhaps that is the real reason it is called the dismal science). The track record of market strategists is equally dismal. Despite this, the press and media focus on forecasts (though rarely holding the forecasters accountable, for accountability would end the game) and investors pay great attention to them; allowing the forecasts to influence or even determine their investment strategy.

Buckingham’s Swedroe on Housing, Oil, Investing

In a recent interview aired on Bloomberg TV, which is well worth viewing in my opinion, Swedroe said emphatically, “There are no good forecasters.”

Not merely offering a criticism of forecasters and prognosticators, he also discusses the “right way” to invest.  Specifically, Mr. Swedroe advises controlling risk by widely diversifying, keeping costs down and keeping taxes low.  And, of course, by not buying actively-managed mutual funds. 

Amen.

Live for Today or Save for Tomorrow

Now that most of us have filed our tax returns (or extensions, if you’re waiting till the last minute again) it may be a good time to think about that other inevitable – death.  I don’t mean to sound morbid, but let’s face it, not a one of us is going to live forever.  This is not exactly an original thought.  Witness the memorable aphorisms of yesteryear.  Tempus Fugit and Carpe Diem.  (For those of you who slept through high school Latin classes, I’ll translate: Time flies and seize the day.)

And witness the recent obituaries – much more than a few – of lovely people who died in their 50s or 60s, an age I now consider young.

Financial planners have to deal with life’s uncertainties and we do our best to prepare our clients for some really unpleasant possible outcomes, e.g. dying very young, becoming frail and needing long term care when very old, or worse, becoming frail and needing long term care when very young.   In many cases, the economic blow can be softened to some extent by buying insurance, whether life, disability or long term care, for ourselves and for our families. 

And since we can not know how long we will live (only that we are living longer), insurance companies have developed a  new policy called “longevity insurance” which only pays off if (and only if) you live past 85.

But life is about more than financing the future.  The other side of saving for “tomorrow” is enjoying “today.”   

Everyone has different goals and priorities.  For some, enjoying today means buying a new and snazzy car, for others, taking a trip to Europe with dear friends or even taking a year off to do charitable work. 

The challenge, of course, is to strike the right balance between current consumption and saving for the future.  And of course what matters is the  kind of life you want.

One life coach uses a series of questions to help clients determine what is truly important to them.  The first question is “If your doctor told you that you had 5 years to live, what would you do now?”  The discussion proceeds from there and can have a striking impact, because it allows you to focus on what really matters to you.

In the future, I will be writing about practical concerns and strategies for spending less and saving more.  But for now I wanted to emphasize that the quality of life should be foremost in our planning.

Risks Worth Taking

Jim Parker of Dimensional Fund Advisors recently wrote a column on the proper approach to risk, as it applies to investing. To me it’s all common sense, but that sometimes is in short supply, just when you need it the most!  Read on to see if you agree.

A wise man once said that to profit without risk and to experience life without danger is as impossible as it is to live without being born. That all may be true, but which risks are worth taking and which are not?

The fact is even the most self-declared risk-averse people take risks every day. There are routine risks to our safety in crossing the road, in riding public transport, in exercising at the gym, in choosing lunch and in using electrical equipment.

Then there are the “big decisions” like selecting a degree course, choosing a career, finding a life partner, buying a house and having children. These are all risky decisions, all uncertain, all involving an element of fate.

In making these decisions, we seek to ameliorate risk by carefully weighing up alternatives, researching the market, judging possible consequences and balancing what feels right emotionally and intellectually, both in the short term and in the long.

Sometimes, we ask an independent outsider to guide us in making our decision. They do this by providing an objective assessment of the potential risks and rewards of various alternatives, by taking a holistic view of our circumstances and by keeping us free of distraction and focused on our original goals.

In investment, this is the value that a good financial advisor can bring—not only in understanding risk and return and how to build a portfolio but in knowing the specific needs, circumstances and aspirations of his or her individual client.

Quite simply, many people who invest without the help of an advisor take risks they do not need to take. They gamble on individual stocks, they rely on forecasts, they chase past returns, they fail to rebalance their portfolios to take account of changing risks and they run up unnecessary costs and tax liabilities.

To use an analogy, this is like trying to cross an eight-lane highway in the face of heavy traffic when there is a pedestrian bridge a little way down the road. You may well get to your destination safely through the traffic, but it will be despite your actions rather than because of them. Understanding risk in investment begins with accepting that the market itself has already done a lot of the worrying for you. Markets are highly competitive, which means that new information is quickly built into prices. Instead of trying to second guess the market, you work with it and take the rewards that are on offer.

Your biggest investment is in spending time with an advisor building a diversified portfolio designed to meet your long-term requirements, then meeting them periodically as your needs change and to ensure you are still on course.

In considering all of this, it is important to understand that risk can never be totally eliminated. If there were no risk, there would be no return. But your chances of a good outcome are far greater if you use the accumulated knowledge of financial science and the guiding hand of an advisor who knows you.

To sum up, risk and return are related. But not all risks are worth taking. The process of working this out starts with not trying to do it all alone.

Crisis Fatigue

When discussing long term investing, I typically go over a list of all of the Bear Markets we have had since World War II, as well as a (fortunately, much shortened) list of some of the crises we have had over the last 50 years. Some were merely figments of the collective markets’ imagination,  some were quite temporary in nature and, yes, there were other crises which were very real and very devastating. But, we survived them all.

The point of this exercise is that, in spite of all of the calamities – wars, inflation, oil embargoes, assassinations, terrorism – the best way to participate in the long term growth of the economy was (and still is) to partner with some of the greatest and strongest corporations in the United States and, indeed, the world, through ownership of shares of stock. Being discouraged, being afraid or even overly cautious was a very bad strategy then, and is a very bad strategy now.

Witness: In January 1973, at the very top of a Bull Market, the Standard and Poor’s 500 Index was 120. From there it declined 45% over the next two years. Pretty terrible, right?

Well, in revisiting Thanksgivings past, here is where that index stood: In 1980 at 140, in 1990 at 315, and now, in 2010, it is close to 1,200. Including dividend income, the rate of return from January 1980 to the present has been approximately 11 per cent.

Yet, in the last two years, the world has seen so many crises that it is difficult to keep track of them – home foreclosures, bank failures, insurance companies in danger of default, the automobile industry in distress, even sovereign nations unable to pay their bills.

Pop quiz! What was the crisis everyone was hyperventilating about early this year? Hint: It was a debt crisis of a country that had had a tremendous building boom. (See the answer at the bottom of this post.)

And the crises keep coming. A while back, I had dinner with a high school friend who asked me if he should be worried about “the Greek Crisis.” I said that he could worry if he wanted to, but that not much was going to change. Now, of course, this year we have had to pay attention to Ireland and possibly Spain and perhaps other places that are nice to visit, but no longer so nice to live or work in.

Am I recommending that you ignore the next crisis? Actually, yes.

Get a Plan

If you already have a plan, you should stick to it, regardless of the Crisis du Jour. If you don’t have a plan, you should get one. Determine your risk tolerance and time horizon, establish an Investment Policy Statement and construct a well diversified portfolio of stocks and bonds.

You could attempt to do this yourself, but you probably should do it with the help of a financial planner who works for you (and not his or her employer).

And then, having carefully designed and implemented a plan that is right for you, do not be influenced by the media coverage of some terrible event which could possibly derail western civilization, as we know it. As before, we will survive it, whatever “it” is.

Stay the course. Stay the course. Stay the course.

For more posts on this subject go to The Education of an Investor.

Answer to the pop quiz: Dubai. Who even remembers that?

For a humorous take on the Dubai hubris, read Dubai Debt Crisis Halts Building of World’s Largest Indoor Mountain Range.

All that Glitters …

Gold – among the most precious of all metals – has been on a tear, having gone up 18% in just the last three months.  Over the last decade, gold prices soared more than 300%.  Should you jump on this gilded bandwagon and attempt to capture possibly even greater returns in the future?

You have heard it said time and time again: There are no sure things in investing.  This year you cannot even count on death and (estate) taxes going together.  But, in general, you cannot win a race looking backwards.  Past returns are, well, in the past. 

Background

There are several reasons why gold is bought.  There is an industrial demand for it, and manufacturers use it to make jewelry.  The recent high interest and demand in gold is because it is perceived as a better store of value and the ultimate insurance for really bad economic times, as in a depression or hyperinflation.  Furthermore, some investors now consider gold as an asset that can help diversify a portfolio comprised of stocks, bonds, and real estate.  (In my opinion, the addition of an asset class usually happens after a sharp rise in its price.)

Looking at not just the recent past but putting gold prices into the historical context of the last 30 years tells a much less favorable story.

The last time we witnessed such high interest in gold was back in November 1979, when the price of gold rose from $400 an ounce to $850 by mid-January 1980.  Investors who poured in – expecting more of the same – were sorely disappointed.  By the end of March 1980, gold was back to selling at less than $500 an ounce, leaving investors who bought at the peak holding a stunning 40% loss for the quarter. Ouch.

Holding onto it didn’t help either.  By the end of the stock market run-up in early 2000, a single ounce of gold was selling for under $300 on the spot markets.

Today, of course, gold is hot; the shiny metal has tested all-time highs almost monthly, leaping from a little over $1,150 an ounce in late July to its latest all-time high, just over $1,365 in the middle of October.  Is it time to jump on this bandwagon and ride the gains up (according to some bullish newsletters) to $2,000 an ounce or higher?  Or is gold an overpriced investment ready to go bust?

Of course no one really knows. Obviously people disagree, as every time someone buys gold, someone else is selling it.

Things to consider

It isn’t real intrinsic demand driving the price of gold higher. Rather, it is investors (or speculators) who are buying at far higher prices than it costs to produce an ounce of gold.

There is no “shortage” of gold, as production over the past five years has been relatively stable at about 2,485 tons per year. In general, new mines are replacing the depleting production of current ones, so there has been little significant expansion in global output.

As prices rise, the market will probably see more recycled or scrap gold – a category which includes people selling gold jewelry. Between 2004 and 2008, recycled gold contributed 28% to annual supply flows.

There is no economic supply/demand imbalance, unless you count thousands of eager investors looking for more price run-ups or a hedge against inflation.

Is gold a reliable hedge against inflation? Since gold’s peak in the early 1980s, the annual inflation rate dropped, but cumulative inflation increased – just as gold was falling in value through the next two decades. According to InflationData.com, gold’s 1980 peak price on the spot market reached $2,250 if it were measured in today’s inflation-adjusted dollars, and the price fell to an inflation-adjusted $370 just two decades later. If gold had been an effective inflation hedge during that 20-year period, the price would have remained the same in inflation-adjusted terms.

So the numbers indicate that for long periods of time (but not always), gold can be a poor inflation hedge.   However, it does appear to be a pretty good “crisis hedge.” When people are concerned about a global liquidity crisis and/or an economic hangover (as they have been for the past couple of years), gold takes off. When the panic subsides, it is reasonable to expect that the price of the precious metal will decline.

Kenneth Rogoff is certainly not a “gold bug”, and he covers both sides of the argument in his article $10,000 Gold?

Pro

“In my view, the most powerful argument to justify today’s high price of gold is the dramatic emergence of Asia, Latin America, and the Middle East into the global economy. As legions of new consumers gain purchasing power, demand inevitably rises, driving up the price of scarce commodities.”

Con

“Gold prices are extremely sensitive to global interest-rate movements. After all, gold pays no interest and even costs something to store. Today, with interest rates near or at record lows in many countries, it is relatively cheap to speculate in gold instead of investing in bonds. But if real interest rates rise significantly, as well they might someday, gold prices could plummet.”

Conclusion

As Martin Feldstein wrote, “ Unlike common stock, bonds, and real estate, the value of gold does not reflect underlying earnings. Gold is a purely speculative investment. Over the next few years, it may fall to $500 an ounce or rise to $2,000 an ounce. There is no way to know which it will be. Caveat emptor.”

I certainly cannot predict whether the current fears will continue to drive gold higher. But history suggests that as soon as people start feeling more secure about the world situation, gold will suddenly lose its luster and leave its investors with significant losses.

If you buy gold now, are you investing or speculating? If you are speculating, is the best time to do it at near-record high prices?

Freedom from the Press

While freedom of the press is crucial to a well-functioning democracy, reading the financial press may be hazardous to your wealth.

One of the worst things investors can do, right now, is to pull out of the stock market because (they think) “the end of the world is upon us.”  The truth is that many people “throw in the towel” at just the wrong time.  And, certainly, the media, all too frequently, plays into (and plays up) that irrational fear, and usually at just the wrong time.

Several articles, had they been taken seriously, might have scared you right out of the stock market.  If you had followed the very typical story line of “now is a very risky time to be investing in stocks” you might have missed out on the best September since 1939.  In that single month, the Standard & Poor’s 500 Index gained 8.8%!

Here are just a few of the recent articles that could have led you astray.  (And note, please, the usage of the word “flee” in the title of the first two articles; I can’t help but relate the word “flee” to those old Godzilla movies, where everyone is haphazardly running for their lives.)

Small Investors Flee Stocks, Changing Market Dynamics, Wall Street Journal, July 12, 2010

“Many individual investors were tiptoeing back into stocks in the spring. Now, they’re running for cover again.”

“Individual investors were important market pillars in the 1990s, but their flight from stocks is changing the market dynamic.”

The article actually pictured a smiling couple who “sold the last of their stock holdings on May 20, moving the money to bonds, certificates of deposit and bond-like annuities.”  What unfortunate timing!  I’d be curious to see if they’re still smiling.

In Striking Shift, Small Investors Flee Stock Market, New York Times, August 21, 2010

Renewed economic uncertainty is testing Americans’ generation-long love affair with the stock market.

Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year, according to the Investment Company Institute, the mutual fund industry trade group. Now many are choosing investments they deem safer, like bonds.

The New York Times and The Wall Street Journal were not alone in trumpeting doom and gloom.  There have been similar articles in USA Today and Fortune.  Even The Atlantic weighed in with a fabulous title: The Great Stock Myth.

For an astute analysis (and a thorough debunking) of the Atlantic’s article, read Larry Swedroe’s August 30^th post, Are Stocks Really Doomed?

Conclusion

What can we learn from reading (and then completely disregarding) such inflammatory articles?  We learn that they are not at all helpful for long-term investing.  Articles of these types almost always appear after periods of low returns and/or increased volatility of stock prices.

What we know is that, yes, stocks are risky.  And, yes, prices fluctuate.  And, (a very emphatic) yes, we are all facing serious economic and political challenges.  And, perhaps some people should have a significant amount of their money invested in fixed income securities. 

But your portfolio should depend on an individual assessment of your goals, your time horizon, and your ability and willingness to accept risk.

Your long-term investment strategy should definitely not depend on – nor should it be influenced by – what you read in the media.

The Stock Market Declined, Now What?

“Don’t let short-run fluctuations, market psychology, false hope, fear, and greed get in the way of good investment judgment.” – John Bogle.

Last week I was contacted by Sarah Morgan, a writer for SmartMoney.com, who had some questions about the recent volatility and decline in the stock market.  Normally, I don’t respond to the press, but her initial question struck me to my core.  Ms. Morgan wanted to know if clients were panicking.  My clients?  Panicking?  She obviously did not know me or my investment philosophy.  My email response to her was this, “I would take it as a tremendous failure of education and preparation if my clients were panicking now.”  

I went on to say that in trying to time the market (which, as I’ve said before, is patently impossible) investors are more likely to hurt themselves by not being invested when the rebound comes.  And, as historical data prove, there is always a rebound, because the long-term trend is up.

I admit that I took pride in being able to tell Ms. Morgan that clients of Key Financial Solutions do not panic.  Rather, they sit and hold tight and ride out the roller coaster.  They’re prepared for short-term fluctuations and declines, simply because they have a long term plan.

Their Investment Policy Statement specifies a well-balanced portfolio that includes a combination of stock mutual funds and bonds (in ratios that we have decided upon, based upon time horizon, risk tolerance, etc.).  So, even a 10% decline in the stock market has little effect on my clients.  And should a market decline be steep enough to affect a portfolio, rebalancing – selling some (appreciated) bonds and buying some (now, underweight) equities – is appropriate to reestablish the portfolio’s target mix.     

That information was enough to spur a half-hour long phone conversation and a follow-up email. 

It was gratifying to read the article, After Market Slide, What’s Your Next Move?, and not just because I was quoted.  No, I was happy to see that Ms. Morgan got it right. She quoted a number of people who said that long-term investing is the key to success.

Having a well thought out Investment Policy Statement is the best chance I know of to stick with a long-term plan.  When markets experience extreme volatility, it sure helps to have a strategy that is based on more than a prediction of what today’s news means to your investment portfolio.

And what are the rewards of long-term investing versus the risk of getting out of the market?  Christopher Davis of Davis Advisors gave a presentation at the NAPFA (National Association of Personal Financial Advisors) National Conference.  Here is what he reported.

Average Annual Returns for 1995 – 2009 for investing in the S&P 500

8.0%		for Staying the Course
3.2%		if you missed the 10 best days
-2.6%		if you missed the 30 best days
-9.2%		if you missed the 60 best days

 

For a fifteen year period, if you missed the 30 best days, you could have managed to lose 2.6% per year, versus earning 8.0% per year.  Thirty days in 15 years!

So let me turn the original question on its head, “Why would anyone risk being out of the stock market?”

Goldman Sachs: Banker or Bookie?

Late last week, the Securities and Exchange Commission charged Goldman Sachs with investor fraud.  It seems that they chose not to disclose all of the terms of one of their own financial products.  After reading the analysis of the events, I have just got to ask:  Are these bankers or bookies?  Goldman Sachs, among other large Wall Street firms, appears to be running a legal bookie operation, catering to clients who wanted to place large bets on the outcome of certain financial events.  You’ve heard the expression, if it walks like a duck and talks like a duck… The real question: was the game rigged?  We’ll have to wait and see.

Last month, in a post about Greed and Delusion on Wall Street, I said

It’s difficult to appreciate the amount of backstabbing, mistrust and cynicism that is endemic at Wall Street firms. “Wall Street doesn’t care what it sells.” Investment banks exploited their institutional customers (pension funds, mutual funds, banks). The same firm that is advising them on what to invest in (the sell side) also has an in-house operation that is trading for its own account. Why is this blatant conflict of interest allowed?

Incredibly, I may have actually understated the problem!  It seems to me that it is patently impossible to be cynical enough, at least about some Wall Street firms.

Why do I say that?  Well, the suit filed by the SEC alleges that Goldman Sachs put together a package of derivatives based on subprime mortgages and did not disclose that the components were selected by the party who wanted to bet against the investment, i.e. sell short.  The claim is that the security was “designed to fail.”  Please take note of the word “alleged,” meaning that they may or may not have done something illegal.  Because it’s a civil lawsuit which may take years to adjudicate, Goldman Sachs will have ample opportunity to present its side of the story.  I have complete confidence that they will hire the best lawyers that megabucks can buy.

Even if Goldman Sachs “wins” that lawsuit, they may have lost something infinitely more valuable – their reputation.  To my mind, this is no small thing, since confidence in your advisor is (or should be) of paramount importance to investment bankers, including Goldman Sachs.  I am compelled to ask one more question, though, did these bankers aim to protect investors’ interests or were they just determined to make a profit at all costs? 

What Is the Public Value of Trading in Synthetic Securities?

But as investors and citizens, it is worth pondering whether all of this trading activity has a social purpose or is it merely gambling in a more refined form.  The topic of synthetic financial derivatives is highly complex and difficult for most ordinary mortals to understand.  But Roger Lowenstein’s column, Gambling With the Economy in the April 20^th edition of The New York Times, offers an excellent summary of the arguments:

Wall Street’s purpose, you will recall, is to raise money for industry: to finance steel mills and technology companies and, yes, even mortgages. But the collateralized debt obligations involved in the Goldman trades, like billions of dollars of similar trades sponsored by most every Wall Street firm, raised nothing for nobody. In essence, they were simply a side bet — like those in a casino — that allowed speculators to increase society’s mortgage wager without financing a single house.

The mortgage investment that is the focus of the S.E.C.’s civil lawsuit against Goldman, Abacus 2007-AC1, didn’t contain any actual mortgage bonds. Rather, it was made up of credit default swaps that “referenced” such bonds. Thus the investors weren’t truly “investing” — they were gambling on the success or failure of the bonds that actually did own mortgages. Some parties bet that the mortgage bonds would pay off; others (notably the hedge fund manager John Paulson) bet that they would fail. But no actual bonds — and no actual mortgages — were created or owned by the parties involved.

The S.E.C. suit charges that the bonds referenced in Goldman’s Abacus deal were hand-picked (by Mr. Paulson) to fail. Goldman says that Abacus merely allowed Mr. Paulson to bet one way and investors to bet the other. But either way, is this the proper function of Wall Street? Is this the sort of activity we want within regulated (and implicitly Federal Reserve-protected) banks like Goldman?

While such investments added nothing of value to the mortgage industry, they weren’t harmless. They were one reason the housing bust turned out to be more destructive than anyone predicted. Initially, remember, the Federal Reserve chairman, Ben Bernanke, and others insisted that the damage would be confined largely to subprime loans, which made up only a small part of the mortgage market. But credit default swaps greatly multiplied the subprime bet. In some cases, a single mortgage bond was referenced in dozens of synthetic securities. The net effect: investments like Abacus raised society’s risk for no productive gain.

Conclusion

I find Lowenstein’s points very convincing, and I totally agree with his recommendations.
“ …the financial bailout has demonstrated that big Wall Street banks … (have) implicit bailout protection. Protected entities should not be using (potentially) public capital to run non-productive gambling tables.
… Congress should take up the question of whether parties with no stake in the underlying instrument should be allowed to buy or sell credit default swaps. If it doesn’t ban the practice, it should at least mandate that regulators set stiff capital requirements on swaps for such parties so that they will not overleverage themselves again to society’s detriment. …”

Proposed reforms by the Obama administration will hopefully rein in the questionable activities of Wall Street bankers, although, Wall Street lobbyists will naturally attempt to defeat any such reform. As I said previously, we’ll have to wait and see, but nearly a week later, no further charges from the SEC have been forthcoming. Of note, however, several European countries have commenced the filing of similar charges against Goldman Sachs.

Apollo 13

“Houston, we have a problem” is one of the great understatements (and oft quoted lines) in movie dialogue. Those words set the stage for the amazing drama of the Apollo 13 moon exploration mission, which took place exactly 40 years ago this month. The great 1995 movie is based on the book, “Lost Moon,” which was co-authored by one of the Apollo 13 astronauts, Jim Lovell, who is played by the ever talented (and understated) Tom Hanks.

No early space mission was ever routine, certainly not in 1970. The astronauts learned their jobs through extensive and thorough training, including hours upon hours of practice in space simulators, reliance on checklists, and their previous experience as (primarily) test pilots. Even so, problems were not unusual.

But the Apollo 13 mission suffered not an ordinary problem but a catastrophic explosion in space, resulting in loss of oxygen, power and a fully functioning guidance system. The 3-man crew faced the possibility of freezing to death, suffocating and being poisoned by their own carbon dioxide exhalation. And that was before they had to manually calculate (on a slide rule, no less) and maneuver their craft into position so that they could get back to earth and land safely, without being incinerated as they passed through the earth’s atmosphere in a module that was damaged to an unknown extent.

At one point, the NASA Flight Director, Gene Kranz, as played by Ed Harris, grandly states that, ”failure is not an option.”  In truth, success was highly improbable.

The movie simultaneously covers NASA’s Mission Control’s race to save the astronauts, what was going on inside Apollo 13, and how the families of the astronauts coped, as the rest of the world watched the events unfold on live television. It is an exhilarating story of calm courage, professionalism, teamwork, perseverance, and ingenuity.

I highly recommend Apollo 13, because it is so realistic, wonderfully acted and tells a gripping story so well. For me, it also doesn’t hurt that it yields a strong dose of optimism about American know-how. Available in DVD, Apollo 13 is skillfully directed by Ron Howard, and has an excellent ensemble cast including Bill Paxton, Kevin Bacon, Gary Sinise and Kathleen Quinlan.

Keeping Your Investment Balance, Part 2

In my last post on the subject, I introduced the idea of monitoring and maintaining a portfolio’s asset allocation. 

Determining when and how to effectively rebalance your portfolio requires careful monitoring of not only portfolio performance, but awareness of your tax status, cash flow, financial goals, and tolerance for risk.  The act of portfolio rebalancing results in transaction fees and has the potential to incur capital gains in taxable accounts. Thus, while there may be good reasons to rebalance, the benefits must outweigh the costs.

Given these challenges, a practical approach to rebalancing takes into consideration the occurrence of “triggering” points, yet provides enough flexibility that costs are effectively managed and minimized.

When to Rebalance

Defining triggering points helps us decide when to rebalance. Most experts recommend rebalancing when asset group weightings move outside a specified range of their target allocations.  This may be widely defined according to either a stock-bond mix or to a percentage drift away from target weightings for categories like small cap stocks, international stocks, and the like.

How to Rebalance

While rebalancing costs are unavoidable, several strategies can help minimize the impact:

• Rebalance with new cash. Rather than selling over-weighted assets that have appreciated, use new cash to buy more under-weighted assets; this reduces transaction costs and the tax consequences of selling assets.
• Whenever possible, rebalance in the tax-deferred or tax-exempt accounts where capital gains are not realized.
• Incorporate tax management within taxable accounts, such as strategic loss harvesting, dividend management, and gain/loss matching.
• Implement an integrated portfolio strategy. In other words, rather than maintaining rigid barriers between component asset classes and accounts, manage the portfolio as a whole.

Conclusion

While there are good reasons to adjust portfolio risk by rebalancing, it does incur real costs that can detract from returns. A good strategy includes determining which investment components can acceptably drift, and adopting tax-saving and cost-saving strategies during rebalancing. In helping our clients rebalance, we strive to develop a structured plan that remains flexible to each individual’s unique blend of goals, risk tolerances, cash flow, and tax status.

No one knows where the capital markets will go—and that’s the point. In an uncertain world, investors should have a well-defined, globally diversified strategy and manage their portfolio to implement it over time. Rebalancing is a crucial tool in this effort.

Moreover, if and when your overall financial goals or risk tolerance change, you have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of guesswork.

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