Portfolio Discipline vs. Active "Timing"

This is an age-old debate, often fueled by the financial press. You see headlines about this stock or that stock or sector returning wildly huge returns. “Why can’t I do that?”, you ask yourself.
In reality, chasing the “wild” return most often leaves you with a depleted account, as many of you can attest, I’m sure.

Another problem is when you see a downturn in the market, like we saw between 2000 and 2002, and you decide you just can’t stomach it any more, so you pull out until its’ “safer” to invest. The problem is that by the time you’ve made your decision to go to the sidelines, you’ve already lost a bunch, and the reversal is right around the corner.

If you got out of the market by September 30, 2002, you missed out on a 20% return over the 12 months to come, using Vanguard’s Total Stock Market Index fund (VTSMX) as an example. But if you had simply stayed in the market, the fund that you purchased in October of 1995 would have, to date, returned a total of 103%, or about 10% a year. The total return for the investor that sold in 2002 would have been 29%, or about 4% for those seven years.

There are three items that make up the discipline I’m talking about here: Asset Allocation, Diversification, and Rebalancing.

Asset Allocation is probably the most important decision you can make with regard to investing, and should be based upon three factors: your risk tolerance; the number of years before you begin taking distributions from the portfolio; and the rate of return required for you to meet your goals. Asset allocation should only be changed when there is a significant change to one of these three factors.

Diversification among the asset classes (stocks, bonds, and money markets) can help reduce many kinds of risks that investors face. Diversification within asset classes can help to further reduce your exposure to risk. Recommending the mix is the job of your financial advisor.

Rebalancing is when you review your accounts once a year to make sure that the “mix” you developed is still on target. If any one asset class or single fund is housing less or more than you originally planned, you need to rebalance.