North American stocks keep climbing and some of them are fully valued, even perhaps a shade expensive. So its no surprise investors are increasingly cautious. A recent survey by Investors Intelligence, a leading provider of research and technical analysis, showed 46% of money managers are bullish, down sharply from 57% in July. More than 37% of managers remain undecided. How about that for fence sitting?
One thing is certain. This has been a very good prolonged market run and a great many people have racked up profits. Its a good place to be but there is a snag. A lot of investors are now over weighted in stocks and exposed to portfolio drift . That can be dangerous.
Drift is when your investments become unbalanced because of unrealized profit or loss. Its also something most of us neglect, especially during a bull market. We have a tendency to leave well enough alone when stocks are rising. Why touch a winning hand? The net result is that after a broad market advance a lot of investors have inadvertently accumulated far too much risk. Their portfolios are skewed and a far cry from the appropriate balance they started with.
Its easily done. Remember the high tech bubble? Defensive investors took small initial positions, enjoyed a fast run-up, and became badly exposed. The bubble burst in 2000 and by the end of 2002 the technology dominated Nasdaq had plunged almost 80%. A lot of people were stunned and seriously hurt.
I am not suggesting for a moment that U.S. and Canadian stock markets are likely to collapse. On the contrary, my feeling is that this bull still has legs although we are bound to have corrections from time to time. My concern is that many conservative investors have become over weighted in equities without realizing it. Drift is insidious. It creeps up on you unnoticed. If you end up with too much money in stocks, a 10% market correction, which is very feasible, could inflict a significant portfolio loss.
Drift is a widespread, on-going problem but solving it is easier said than done. Seasoned money managers all agree about the menace of imbalance but they differ about how to deal with it.
One school of thought is that you should review your portfolio at regular intervals, some advisors suggest at least every quarter. Dump investments that have increased in value and load up with the laggards. Its a rigid technique that theoretically allows you to take profits gradually in a rising market and accumulate relatively cheap securities.
In practice, however, a quarterly pruning can be very expensive. For example, if your portfolio now consists of 75% stocks and 25% bonds, having drifted from an original 50/50 split, an automatic reallocation would involve buying bonds at exactly the wrong time. Their yields are almost non-existent while gradually rising interest rates are bound to drive bond prices lower. At the same time, stocks that have appreciated may still represent good value and provide upside potential. You could be sacrificing a significant total return just to bring your holdings into line.
Another approach is to ignore drift altogether and allow counteracting market fluctuations to eventually bring your weightings back into line. This would eliminate the continuing stress and cost of buying and selling. It sounds attractive but there is no proof that portfolios tend to realign. As a matter of fact, an analysis by Source Wealth Management Systems shows that market activity throws a portfolio more and more out of sync with its original allocations.
One detailed study involved a carefully assembled mainstream U.S. portfolio with 30% bonds and 70% stocks that was left unbalanced for 20 years ended on Dec. 31, 2013. Stocks eventually represented 83% of the holdings while the fixed income safety component had shrunk to 17%. The message is clear: we cannot ignore drift. The trick, though, is to keep it in perspective. Never let it dictate your investment program.
The best bet is to factor portfolio balance into the process whenever you are buying or selling securities. Make it part of the decision making process and above all remain flexible. Your original balances are not carved in stone. Personal circumstances, needs, and risk tolerances are constantly changing. Think in terms of the here and now, not the situation when you established the portfolio. Just remain aware of how much risk you have at the moment and weigh whether its acceptable.
Above all, steer well clear of automatic rebalancing programs. These tend to cloud your investment judgment and there is a temptation to dump winners because they have a good run and keep losers that may be lagging for good reason. Focus on individual securities, not some formula.
Always keep in mind that the arbitrary divisions between bonds and stocks are misleading. There is no clear-cut separation of safety and danger in the markets. A lot of bonds are high risk, almost speculative, while some blue chip stocks such as the leading Canadian banks are relatively secure. The balance most people are seeking is between defensive securities and more aggressive issues.
They also look to their safer investments for dependable income and bonds are not offering that at the moment. For example, the Government of Canada 3.25% bonds due June 1, 2021, were recently priced at $109.86 to yield 1.7%. With inflation running at 2.1%, that is a negative return even in tax protected registered accounts.
On the other hand, you can make your portfolio more defensive by switching funds from high growth common stocks paying little or no dividends to utilities such as Fortis and earn an almost 4% yield along with increased stability.
Its also possible to factor more or less risk into your portfolio by allowing for the state of the market. If you are concerned about your stock mix, shift funds to sectors with downside protection based on historical performance.
[sharify]
