Wednesday, February 29, 2012

Diversification , Allocation and Rebalancing - When to do it and How Not to do it.

There once was a time when an investor could follow the example set forth by one Rip Van Winkle and effectively sleep through his investing life and "wake up" at the end, ready to retire and life the good life. Or maybe that was never true. Maybe that's always been a fable. I don't know. What I do know is that now is not the time be a Rip Van Winkle with your investments.

There are two basic reasons this is true:

1. cyclical rotation.
2. volatility.

Cyclical rotation.

10 years ago, banks and airplane stocks may have been roaring, but you would not have wanted to be holding them through the 2008-2009 period. One could argue they are a good buy at today's prices, but you would be hurting had you held onto them. Same was true of tech stocks at the start of the new millennium. The same will be true of today's hot sector too.


The trend since 2000 has largely been one of uncertainty, and uncertainty breeds volatility. This trend has only been amplified by the events of the housing collapse of 2008 and the debt crises of the developed nations.


If your portfolio represents a pie and the entire pie is your entire money you have invested, then diversification is simply how you divide your portfolio pie.
My kind of pie.

It may be split among stocks, bonds, cash, real estate and commodities but that is largely dependant upon these 3 factors:

  • Your objective.
  • Your risk tolerance.
  • Your time frame.

You're going to (or you should) invest differently for retirement than you would for buying a new house. One you have decades of time to amass wealth (retirement) while the other is typically less than a decade. That time frame may affect your risk tolerance, or you may just be sensitive to risk no matter the objective. Either way, how you feel about risk will affect what you put your money in.

But it's not that simple...

Say you start your portfolio at 75% stocks, 25% bonds - this is a simple scenario for example purposes. Over time, that allocation will change. Let's suppose that stocks go on a tear and bonds languish. A few years go by and now your pie looks more like 85% stocks and 15% bonds.

Who cares, right? Your portfolio grew, so it's good. But what if stocks take a dive? You now have far more of your pie in stocks and so you will take a bigger hit. The key to avoiding this situation is called rebalancing.


Rebalancing is simply re-adjusting your portfolio allocation to realign with your original (or current) target allocations. In the example above, you would sell some of your stock holdings and increase your bond investments to get back to your target 75/25 allocation.

But there's one more level to allocation...


"How you allocate within an asset class is as important as how you allocate between asset classes."
-Jim Randel, author of

Many individual investors practice a kind of diversification in name only, and don't even know it. For example, let's say you take your 75% to be allocated to stocks and pick 3 different stock ETF's:

  • Vanguard's VOO

Each of these is a prominent, broad based stock ETF which is what you would want. The problem though is that each one is an S&P 500 Index ETF, meaning that each track and hold the same basket of stocks. You have essentially tripled your fees by diversifying in fund companies, while not diversifying your holdings.

This is why it's important to look beyond performance and fees when picking a fund. You should also look at the fund's holdings to make sure you keep any overlap to a minimum. It's nearly impossible to eliminate overlap because some companies may be considered growth by some fund managers and value by others.

Some thoughts on rebalancing.

Beyond the periodic realignment of your allocations to your desired targets, you may want to reevaluate your target allocations from time to time as well. That is - should you change the percentage of those pieces of pie.

One factor that should trigger a change is nearing the retirement red zone. This is the period before retirement, usually about the 10 year mark. By that time you want to begin decreasing stock and growth allocations and increasing bond, income and cash allocations. Another factor that may change your target allocations is the state of geo-politics and world. Jim Randel recommends assessing how you feel about geo-politics at least once a year and asking yourself whether you feel expansive or contractive. Let that color your allocations for the year ahead as well, just don't use that as your only metric.

You can watch an interview with Jim Randel below:

Thursday, February 23, 2012

Some Thoughts On Investing Vs. Speculating And Fundamental Vs Technical Analysis...

"The attempt to predict accurately the future course of stock prices and thus the appropriate time to buy or sell a stock must rank as one of investors most persistent endeavors."

Technical analysis (a.k.a. charting) is, at its most basic, the creation and interpretation of stock charts. The most fervent practitioners are called "chartists". Most chartists believe the market is 10% logical and 90% psychological. That is, chartists believe that the market is driven by the average sentiment of investors at any given time. This is very much like choosing stocks based on what you think other investors think (or will think) about the stock in the future. It's more about analyzing and predicting crowd behavior than the success or failure of a given business.

Fundamental analysis is the antithesis of technical analysis. The fundamentalist believes that the market is 90% logical and 10% psychological. They are called fundamentalists because they see the future value of a stock as the result of the future condition of the business fundamentals. That is, the value of the stock is the result of the value of the underlying business - ie. growth, earnings, cash flow, debt, etc...

Which is right?

A primary tenet of charting states that all that is knowable about a given stock is already reflected in it's price. This means that the historical chart contains the aggregate effect of all past dividends, splits, earnings, growth rates, etc - all the fundamental aspects of the stock.

The secondary tenet is that prices tend to move in trends - downward trends,upward trends or flat lined. A head-and-shoulders chart means the same for Google stock as it does for Alcoa. Chartists believe that any important fundamental factors of a stock are already "baked into" the current price. All that is knowable is reflected in the chart.

Charting works wonderfully, until it doesn't. Trends reflect the mass psychology of the crowd and can hence sustain a stock price to the point where it becomes self-perpetuating. The problem is that this leads to bubbles, and bubbles eventual burst. Charting and technical analysis can work in the short term,but when the trend reverses you can get caught catching the blade of the falling dagger.

Falling trends alone is very speculative. It's investing in stocks instead of businesses and it ignores all rationale in favor of crowd psychology. Speculators and chartists end up investing in something they don't (and can't) understand. The trend is ultimately, rarely explainable. It may be real, but it is also usually ephemeral and without a logical cause it is impossible to make a rational investment- you are simply chasing trends.

All this trend chasing leads to much trading, and this can quickly add up to high trading fees. It's not uncommon for traders (i.e.: speculators/chartists) to eat up their profits in trading fees.

All this does not mean that technical analysis is bad or useless. It just depends on how you use it.

Asking if Technical analysis is better than Fundamental analysis is a little like asking if Einstein's Theory of Relativity is better than Quantum Mechanics. The answer is neither - they are two different ways of viewing the universe and each works in its own space.

Einstein's theory predicts how matter behaves in the universe on a large scale while Quantum Mechanics predicts the behavior of matter in the sub-atomic realm.

Fundamental analysis works best for the long haul (like Einstein's theory) because the trend line is trending toward infinity. For example: the stock market as a whole will certainly be higher in 100 hundred years than it is today. But as that time period lessens, it becomes harder to say with certainty where prices will be. Can you make the same prediction of prices 1 year from today?

Technical analysis can help to predict these movements over shorter periods of time, but as discussed above the fees associated with chasing these trends can quickly eat up your returns.

My personal view (and this is just my opinion) is that investors should favor fundamental analysis for picking stocks to invest in for the long term (3 years or more), but use technical analysis to determine the bets (or at least better) time to buy and sell.

By using fundamental analysis to create you watch lists, and technical analysis to develop your trigger points you are utilizing a holistic approach that makes the best of both.

Tuesday, February 14, 2012

Stay the Course! 401(k) Savers Who Stuck With Stocks Saw Gains.

"401(k) account owners who maintained their equity allocation and continued to save during the market decline of 2008 and 2009 now have much larger account balances than investors who stopped saving or pulled their money out of the stock market, according to a new Fidelity Investments study"

The study was conducted by Fidelity Investments between Sept. 30, 2008 through June 30, 2011. The sample consisted of nearly 20,500 401(k) plans with more than 11.6 million participants. Here are the highlights of that study:

  • Investors who did nothing during and after the stock market plunge, and continued making contributions in their 401(k) plan as usual saw their 401(k) balance grow an average of 50% .

  • 401(k) participants who withdrew all of their money from the stock market during  the lowest months of the market downturn, and never moved any money back into stocks saw only a 2% increase in their balance, on average.

  • Those who pulled everything out of the stock market, but went back in after the bulk of the market decline saw an average of 25% increase in their 401(k) balance.

  • Participants who stopped contributing during the meltdown, but left their allocation untouched saw an average increase of 26%.

  • Participants who increased their contributions, and left asset allocations untouched saw an average increase of 64%.

These point highlight that even a temporary exit from the stock market is enough to negatively impact the growth of your 401(k).

Investors get anxious when the market gyrates and become downright panicked when it crashes as it did in 2008-2009, and that understandable. Fidelity states that calls from concerned customers spiked again in the summer of 2011. But such volatility shouldn't affect you if you have a proper allocation. In fact, the above bullet points reinforce that staying the course and even doubling down - on a properly diversified allocation - is the best course of action. The second best course is to do nothing at all. The trick is being properly diversified.

Here are a couple of resources to get started on diversification and asset allocation:

Get a better understanding of two different types of risk.

Investing 101 -- The Importance of Sector Diversification

What Does Asset Allocation Mean?

Asset Allocation: The First Step Towards Profit

Introduction To Investment Diversification

6 Asset Allocation Strategies That Work

Thursday, February 9, 2012

PREDICTION: 6 to 12 Months Hence, Investor Sentiment Will Turn Against Apple.

This isn't my prediction. Well, not entirely. While I have made similar predictions in the not so distant past, I would never be so bold as to attach a time period to my predictions!

This prediction comes from David Garrity who is a tech analyst at GVA Research. It stems from Apple's latest announcement to begin selling text books to iPad users. This non event may be the catalyst for the ultimate demise of Apple.

From a recent Breakout interview on Yahoo! Finance :

"The issue still comes down to vision, or perhaps lack thereof, coming out of Cupertino. "Clearly we do have a vacuum, from a marketing standpoint," says Garrity. "From a presentation standpoint and, perhaps over time, we'll have a deficit from a vision standpoint.""

This is not too far from my own views on Apple and the death of Steve Jobs, as expressed in A Tale of Two Apples.

The cloud that hovers over Apple these days is one of vision for the future. Steve Jobs clearly had it, and he knew how to wield it most effectively. The question now is, does any would be successor have the vision and can he wield it to similar effect. The jury is clearly out on this question, but Garrity suggests the jury may have its decision within the year.

We'll wait and see.

For what it's worth, I think Steve Jobs is irreplaceable and once the pipeline of Jobs' ideas is spent, the world (and investment community) will turn its back on Apple, leaving it to languish as it did through much of the 1990's.