June 3, 2010
Paul from Piscataway, NJ writes:
Like many of my friends, I sold my stocks after the market cratered because I could not stand to lose anymore. The market rebounded so quickly, I feel like it got away from me. Most of my investment dollars are still sitting in cash earning next to nothing. Even with a 10% correction, I feel like I can’t pull the trigger. How does one get back to a well rounded portfolio after missing one of the biggest 1 year rallies in history?
You are certainly in good company. Many people now realize that they had too much exposure for their comfort level. That can be tough to recognize while the market is doing well. Step one, in a good investment plan, is ascertaining the right level of risk that is appropriate for you. Whether you are a buy and hold investor or prefer adjusting your asset allocation, the key is having the discipline (and objectivity) to stick with the plan. All too often investors let their emotions dictate their investment decisions. How often have you heard someone say (or felt) “I’ll just wait until the stock gets back to where I bought it?” At any given point in time, investors should ask themselves what portfolio they would choose if they started “today” with cash. Anything that’s not in that portfolio should generally be replaced by something more suitable. (ok…we still have to be mindful of large tax consequences, but that’s beyond this discussion…) The determining factor is not if a particular investment is expected go up or down in the future. It is which combination of investments is expected to perform the best, given constraints for the investor’s risk tolerance.
Getting back to your question….how should one get back in to the market in a prudent way? Following the logic above, an investor would just buy “the” portfolio in one fell swoop. However, given recent market volatility, timing your entry feels completely untenable! Therefore, once you have determined an entire portfolio that is suitable, consider choosing 4 dates over the next 2 months (in advance) and invest 25% on each. Select each group (1/4th) such that you spread around similar investments across the 4 days (i.e. DON’T buy the domestic equities on the 1st day, fixed income on the 2nd day, commodities on the 3rd day, and international on the 4th day) This method will allow you to reduce your entry risk without quadrupling your commission costs. There is no magic to this…but at least you won’t feel like you took the leap all at once.
Maintaining discipline in the face of market volatility can be very difficult for many investors. For this reason, it is important to have a well thought out plan before you face this turbulence. (For the same reason, never go food shopping when you’re hungry!) As you create your investment portfolio, consider the following.
Am I selecting individual securities or investing in funds?
There are certainly investors that enjoy the flexibility to buy specific securities. However, it takes quite a bit of time to analyze an issuer of debt or equity securities to determine if it is desirable. So, evaluating enough of them, with enough frequency, is often impractical. We prefer efficient Exchange Traded Funds (ETFs). We ONLY use those which are liquid (narrow bid/offer spread), transparent (can see every investment owned by the ETF), and have relatively low costs (expense ratio compared to peers). We do not recommend using any ETFs which track an inverted index or use leverage. It’s not that these are categorically bad….just often lack the transparency that we require. Also note that ETFs that track an inverted index do so logarithmically. So, if that’s not desired (or you don’t understand it)…don’t use these types of ETFs! When investing in individual Fixed Income securities, keep in mind that there is often a wide bid-offer spread (you can’t sell it for a price close to what you paid for it) for retail investors. Fixed Income ETFs generally resolve this issue, since the funds trade as equities with generally better liquidity for retail investors.
How correlated are my investments?
Many investors simply think of investments as stocks, bonds, or commodities. In reality, there are many subsectors. It is common for some of these subsectors to be correlated with those from other asset classes. For example, corporate bonds (high yield, especially) have a strong correlation to the stock market because corporate credit spreads (like stocks) are a reflection of perception of general risk in the economy (See charts below). Although correlation can be measured, it is always retrospective, and it can vary over time. Even as such, it is important to recognize the directionality of the correlation and the general magnitude.
- High Yield Corporate Bonds vs Aggragate Bond Index
The scatter plots above shows the difference in correlation between high yield corporate bonds (JNK) vs. the US stock market (SPY) and high yield corporate bonds (JNK) vs. an aggregate bond index (AGG) . Comparing these charts, it is clear that high yield corporate bonds tend to have a much larger relationship to stocks than to a broad basket of bonds. Source :Bloomberg LP
What is my time horizon? What is my comfort with volatility?
This includes needs for your capital, or potential needs. Younger investors generally have the time to ride out market volatility. Many of them still choose to reduce some risk given the need to liquidate if they lose their income. Consider how much you will spend per month if you lost your job and multiply by the number of months anticipated to replace your needed income. For those closer to retirement, anticipated time frame and income needs relative to assets, are generally the largest influence of an investor’s desired risk tolerance. In addition to these factors, personality is important. Some investors don’t worry about their portfolios and others experience great stress when their investments fluctuate in value. It is important to know yourself when determining the appropriate risk level.
Once you’ve determined the right portfolio for your needs, be sure to consider which securities are most advantageous to be placed in your IRA as opposed to your taxable brokerage account. Generally, those investments with the highest non-qualified dividends (which are taxed at the investor’s marginal income tax rate) are best suited for the IRA (or other tax deferred account). Obviously municipal bonds are best suited for the taxable brokerage account. Keep in mind that ETFs are taxed based on the characteristics of the underlying securities. Non-qualified dividends may represent a percentage (not “”all or none”) of the ETFs dividends. Each ETF discloses this retrospectively (at least annually). While we recommend considering this in advance of your investment decisions, your custodian/brokerage firm will ultimately disclose it on your 1099 statement to the IRS.
We hope that helps and provides fodder for discussion. Please let us know if we can be of further service!
The Friedenthal Financial Team
Please send us your questions!! If we don’t know the answers, we’ll find someone who does!
If you know someone who would like to discuss their investment needs with us, we certainly appreciate the introduction.