What to do now?
“What should I be doing now?” is the question investors are putting to their advisors. “Nothing” is almost always the wrong answer - but still, this is the answer most often received. Investors and advisors alike are now discovering the ‘fear’ part of the ‘fear and greed’ equation.
In fact, what you should do now depends on what you were doing before the downturn. If you were in a properly diversified portfolio before the down turn, what you do now is simply rebalance – effectively ‘buying low and selling high’. If you were in the wrong asset mix before the down turn, then the smartest move today is to make the changes necessary to get into the correct asset mix.
Most investors understand the benefits of a balanced portfolio. However, when there is a long equity bull market, the asset allocation tends to drift further and further from the strategic target. Over time, this drift can significantly change the risk and return characteristics of your portfolio, to the point where it may no longer be in line with your risk tolerance comfort level.
Consider two cases. Case # 1 the investor was following an investment process whereby 50% of the portfolio was in bonds and 50% was in equities. This was the asset allocation which could reasonably be expected to yield 6% over the long term and this was the rate of return required to achieve the long term objectives. After the recent downturn equity assets had dropped in value as shown below.
Case # 1 – Investor is properly balanced before the downturn
| Starting asset mix Assets Jan 2008 | Asset mix October 10th (Before Rebalancing) Rebalancing required | Asset mix October 10th (After Rebalancing) Target asset mix | ||||
| Cash and fixed income | 50% | $300,000 | $300,000 | -45,000 | $255,000 | 50% |
| Equities | 50% | $300,000 | $210,000 | 45,000 | $255,000 | 50% |
| Total | 100% | $600,000 | $510,000 | $510,000 | 100% |
In this case the investor should sell $45,000 of bonds and buy $45,000 of equities and the portfolio is then at the desired target asset allocation.
Case # 2 – investor was in a too aggressive asset mix before the downturn
It is the investors who were in asset mixes that were too aggressive at the beginning of the year who have now lost more than expected and more than necessary. If investors were too aggressive before the down turn they are most likely still in too aggressive an asset mix. Conventional wisdom is that you never sell when the market is down – but that wisdom is best applied in cases where the investor was taking the appropriate amount of risk to begin with. If it’s the wrong asset mix, e.g., too much in equities – it’s the wrong asset mix. The sooner investors in the wrong asset mix move to a more appropriate one the sooner they’ll start to sleep at night. For certain they will ‘lock in’ higher losses when they move to the correct asset mix after the market has just dropped by 25% - but the cost could be even higher if the market drops by another 25%. The standard refrain in the industry is that one should never sell when the market is down by 25%. But we say – unless you are certain that further losses are impossible – you are taking more risk than necessary if you delay moving into a sensible asset mix – even if it means locking in capital losses.
In the following example the investor was in an 80/20 mix between equities and fixed income and a 50/50 target mix would have delivered the long term rate of return necessary to achieve the financial goals. In this case the correct move is to sell $108,000 of equities (take your lumps) and buy $108,000 worth of bonds.
| Starting asset mix | Assets Jan 2008 | Asset mix October 10th (Before Rebalancing) | Rebalancing required | Asset mix October 10th (After Rebalancing) | Target asset mix | |
| Cash and fixed income | 20% |
$120,000 | $120,000 | 108,000 | $228,000 | 50% |
| Equities | 80% |
$480,000 | $336,000 | -108,000 | $228,000 | 50% |
| Total | 100% |
$600,000 | $456,000 | $456,000 | 100% |
If the asset mix was only slightly more aggressive than necessary before the down turn natural market forces may have performed the necessary rebalancing and nothing more needs to be done at this time. In the chart below the investor was in a 60/40 asset mix between equities and fixed income and as a result of the market decline the asset mix is closer to the 50/50 that was the appropriate asset mix to begin with. Here a small $6,000 adjustment is all that is required to bring the overall asset mix to what it should be.
Even though the adjustment to bring total equities in line with the target asset allocation is only $6,000, additional changes may be required. For example, sector weightings may now be out of line and one might find that the allocation to a particular sector should now be increased or reduced.
| Starting asset mix | Assets Jan 2008 | Asset mix October 10th (Before Rebalancing) | Rebalancing required | Asset mix October 10th (After Rebalancing) | Target asset mix | |
| Cash and fixed income | 40% | $240,000 | $240,000 | 6,000 | $246,000 | 50% |
| Equities | 60% | $360,000 | $252,000 | -6,000 | $246,000 | 50% |
| Total | 100% | $600,000 | $492,000 | $492,000 | 100% |
A down turn such as this one is also an excellent opportunity to harvest income-tax losses. This is easily done by, for example, selling one bank stock at a loss and buying a different bank stock which has also fallen in value. This transaction does not change your overall exposure to the banking sector but it gives you a capital loss that can be carried back to recover capital gains taxes paid in the previous three years.
There is a trade-off between risk and return. Investors have to accept the fact that they can’t have it both ways. If they want to significantly reduce the risk in their portfolio they are also going to have to reduce the potential upside.
