Most Popular ArticlesTed A. Ponko, CFA
October 27, 2009
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Sharp losses in the equities markets have wiped out billions of dollars of wealth. To their credit, investors haven’t started a panic-driven sell off, but many are definitely rethinking the structure of their portfolios. The natural reaction is to abandon riskier assets, regardless of price, and to head for the safety of cash. At times like these, advisors exhort their clients to stay the course by sticking with their long-range plan.Â
For many investors, particularly younger ones with many years of growth ahead of them, this is the best advice. The longer the investment horizon, the greater the opportunity to recoup losses and magnify gains on purchases made when financial assets are on sale, as they are now. The recent declines can actually work to the benefit of these long-term investors.
But what about the 50-year-old who plans to retire within the next decade? What about the 40-year-old who has just seen her wealth drop over 40% in one year? And what about the 30-year-old with a young family who just lost his job? Should any of them stay the course?Â
The issue is much more complicated than simple reactions to short-term losses. Instead, it involves investment time horizon, current and expected cash flows, and – most importantly – the investor’s comfort level given his or her newly diminished wealth. Isn’t it reasonable for investors’ objectives to change along with major fluctuations in their wealth? In these instances, sticking with the current portfolio may not be the best option – even for long-term investors. Advisors need a reliable way to determine when to stay the course and when to plot another.
Constant risk
Is it reasonable to assume investors are comfortable with the same level of risk regardless of their overall wealth? Many advisors do when helping clients set goals for the long term. Consider, for example, a 30-year old with investable assets of $100,000. After profiling him, the advisor suggests a 60/40 split between stocks and Treasury Bills. In this case, 60 percent of the portfolio is invested in risky assets. If stocks rise by an annualized 9.6%, and the Bills grow by an annualized 3.7%,1 then at the end of the fourth year the portfolio ends the period as a 65/35 split and valued at $132,832. At this point, the advisor would rebalance back to the original mix by selling $6,876 from the stocks and buying a like amount of Treasury Bills. In a fluctuating market, this approach is effective because it leads to selling the more highly appreciated asset and buying the cheaper one. In essence, it forces the investor to buy low and sell high.
But it works against the investor in a down market. Consider 2008, when the total returns were -37% for the S&P 500 and +2% for 30-Day Treasury Bills. The portfolio’s value would have fallen from $100,000 to $78,436, leaving 48% in the S&P 500 and 52% in Treasury Bills. In order to balance back to the original 60/40 mix, the investor would have to shift $9,262 from Bills to stocks. As before, he is selling the appreciated asset and buying the cheaper one, but this time it’s against the backdrop of a 37% loss in the asset being purchased and a 22% loss in the overall portfolio. If this is the investor’s total wealth, he’s lost 22% in one year. If he has other assets, such as a home or a 401(k), he probably lost similar amounts there – or possibly more.1 These are Ibbotson Associates’ historical returns for the S&P 500 (extended) and U.S. Treasury Bills for the period January 1926 – December 2008.
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