Principles of Sound Investing
Chasing performance
Chasing performance is buying what's hot, whatever type of investment has been performing well lately. When you hear about the spectacular performance of some stock, or fund, or asset class, it's tempting to jump on the bandwagon and buy it. If it goes down, then you may sell it in order to jump on some new bandwagon.
But the very idea of chasing performance suggests that one is always one step behind, buying something after it's gone up and selling it after it's gone down. So chasing performance often means buying high and selling low, which is the best way to lose money. It may also mean paying a lot of brokerage commissions on the frequent trades.
Chasing performance by buying market-beating mutual funds can also have unfortunate consequences. In fact, it can explain something that seems paradoxical about mutual fund returns. Consider a successful fund with an average annual return of 15% over a five-year period. Sounds great, but it's very unlikely that the average investor in the fund actually got that 15%. In fact, recent research shows that the typical investor does substantially worse than the funds in which he or she invests. How can that be? It could be because most of the investors got into the fund late, only after they heard about its success from the media. Since as we've seen, market-beating performance is difficult to sustain, many investors miss the outstanding years, which may have been a lucky streak, but are still in the fund when it has some more disappointing years.
Some mutual fund companies have taken advantage of investor behavior by rushing to market new funds focused on whatever type of security has been hot recently. They have made millions in fees while setting their investors up for disappointing returns. When these losses are added to the other costs of mutual fund investing, such as unnecessarily high turnover of holdings and high fees not justified by superior performance, a substantial portion of potential returns can be lost to investors. For a critique of the mutual fund industry along those lines, see John Bogle's The Battle for the Soul of Capitalism. Bogle is the founder of Vanguard and the foremost advocate for low-cost index funds.
Looking for buying opportunity
What everyone would prefer to do is anticipate good years in advance, so they can buy low and sell high. Trying to anticipate the ups and downs of the market is known as "market timing." Whether that is really possible is a matter of debate. Many financial planners discourage trying to time the market, because the markets are just too unpredictable. They recommend a buy-and-hold strategy. Put together a balanced portfolio, hold onto it for a while, and don't worry too much about the market fluctuations.
One weakness of the traditional asset-allocation approach, however, is that it pays little attention to the current valuation of different assets. Markets sometimes suffer from what Alan Greenspan called "irrational exuberance," over-valuing an asset that is currently popular, such as technology stocks in the 1990s or real estate in the 2000s. Or investors may get discouraged about recent returns and under-value an asset, such as stocks in the 1970s. The tendency to follow the crowd exaggerates these movements, as people rush to buy or sell because everyone around them seems to be doing so. Such behavior creates opportunity for a "contrarian" approach, one that tries to go against the prevailing market psychology. You would want to buy more stock when pessimism about the economy has driven prices down to unreasonably low levels. You would want to buy more bonds when pessimism about rising interest rates has driven bond prices down. You have to be able to take the long view, and be optimistic about the long-run outlook for stocks or bonds or real estate when other people are overreacting to recent bad news. You must also be willing to sell when others are still bidding up the price of what you have bought. Sell too early and you miss a lot of the gains; sell too late and the bubble may already have burst.
Historical data on stock returns support the reasonable idea that buying stocks when they are less expensive usually results in a higher long-run return than buying stocks when they are more expensive. A common indicator of how expensive they are is the price/earnings ratio of the entire market, which can be obtained from many financial magazines or websites. A P/E over 20 indicates that stocks are unusually expensive; a P/E under 12 indicates that they are unusually cheap. (Because of anomalous fluctuations in reported earnings, it is best to use an average of earnings for the past five or ten years as the E in the ratio.)
Many financial planners distinguish "tactical asset allocation" from the more radical and less desirable practice of market timing. At its extreme, market timing would mean moving a large portion of your assets out of the market when you think it is peaking, and moving back in when you think it is bottoming out. Tactical asset allocation maintains a reasonably balanced portfolio at all times, but does more buying of a given asset when it is cheap and less when it is expensive. The timing of transactions is simply a tactic to carry out a long-term strategy based on a reasonable asset allocation (see section 5). The allocation to a particular asset class can be flexible, such as a range of 40-60%, allowing for increases when that class is less expensive and reductions when that class is more expensive.
Portfolio rebalancing
Even a constant allocation, such as 50% stock, can help you take advantage of market opportunity. If stocks underperform your other investments, the stock portion of your portfolio will fall below your target, and you can then buy enough stock to restore the desired allocation. If stocks outperform your other investments, you sell some stock. As a result, you will naturally tend to buy when prices are lower and sell when they are higher. However, research by David Smith and William Desormeau (Journal of Financial Planning, 11/06) suggests that investors shouldn't rush to rebalance whenever their allocation gets even a little off-target. That's because market ups and downs tend to occur in consecutive quarters or even years. If your stocks are up this quarter, they may be up next quarter too, so don't sell too quickly in order to rebalance. But don't wait forever, either, because sooner or later a market correction will occur. Rebalancing is a good idea, but so is a little tolerance for a temporary imbalance.