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Think Of Long-Term Goals Before Tweaking Your Portfolio

By Werner Renberg

It's that time of year when, if you haven't done it already, you probably should take a look at how your mutual fund portfolio is allocated among the three principal asset classes -- stock funds, bond funds, and money market funds -- and judge whether you need to do any rebalancing.

The reason this exercise is recommended is that, according to academic research, how your assets are allocated could be the most significant factor in determining both your long-run investment results and your portfolio's short-term volatility.

If there is anything you can do to influence the performance of your portfolio, it is to raise the probability that its composition is consistent with both your investment objectives and your tolerance for investment risk.

In contrast with recent years, when the stock market's performance may have caused your equity allocation to overshoot its target, last year your bond allocation may have done so.

You may believe that your task of rebalancing your portfolio is more challenging now because of the unusual coincidence of major elements in the economic and financial environment:

o Stocks, on the average, seem to remain highly priced in relation to earnings or other variables even after a year in which many have gone down sharply.
o Bonds, on the average, have gone up -- largely because of investor confidence that the Federal Reserve has helped to check inflation -- thereby providing long-term bond yields 0.5 to 1.0 percentage point lower than a year ago. 
o A significant number of corporations have been reporting disappointing earnings.
o Talk of "economic slowdown" and "a possible recession" has increased. Although the current expansion has been setting a record every month since last February, when it became 107 months old, real gross domestic product (GDP) was still increasing at an annual rate of 2.4 percent as recently as the third quarter. If that was down from 5.6 percent in the second quarter, the economy was still expanding.
o President Bush is committed to recommending to Congress a program of individual income tax cuts, which would be expected to stimulate consumer spending -- the largest component of GDP. Given the makeup of the new Congress, the ultimate fate of Bush's program is uncertain, as is the Fed's eventual monetary policy response to any fiscal easing that would coincide with its own.

Should important, negative elements of the current economic landscape such as these be the key factors on which you base your mutual fund portfolio's asset allocation?

No.

Given that you are, presumably, invested in mutual funds for the long run, such interim developments and near-term prospects are less important to your choice of whether to be X or Y percent invested in equity funds than your own long-term investment goals and your level of risk tolerance.

"Having an asset allocation that is appropriate for an individual's risk is really the bottom line," says Jeffrey S. Molitor, Vanguard principal and its director of portfolio review, whose group analyzes the performance of Vanguard funds and their competitors.

Correcting those who assume that all people of a certain age have the same risk profile and who, therefore, recommend an allocation based on the one-shoe-fits-all-feet theory, Molitor emphasizes, "That doesn't make a whole lot of sense. You can have a 35-year-old and a 65-year-old who might have the same risk profile because of their other assets, income, or whatever."

If he were in your shoes, he would:

1. Have "a well-defined asset allocation" for the long run. It can be 60-40 equity/bond funds, 50-50, or some other mix that seems appropriate. The more you have in equity funds, the higher would be your expected long-term return and short-term risk; the more you have in bond and/or money market funds, the lower both would be.
2. "Recognize that at some points stocks are cheaper than bonds and at some points bonds are cheaper than stocks on a risk-adjusted basis." At such points, he would raise the allocation of the "cheaper" asset class.
3. "Having some sort of mechanism to tilt the allocation makes a lot of sense -- but not one that is so sensitive as to make small changes, which can subject you to a lot of whipsaws."

Molitor's points can be illustrated by the asset allocation methodology used by Mellon Capital Management Corp. in managing Vanguard Asset Allocation Fund. Its computer model revises expected long-run returns from stocks, bonds, and cash as new economic and financial data become available and recommends allocation changes, in 10 percent increments, on the basis of which asset mix seems to offer the best combination of expected returns and risk.

For a number of months, the computer has called for a 50-50 equity/bond split, but, after stock prices fell sharply in the autumn -- without, as Molitor points out, a decline in stocks' expected long-term earnings -- the model called for a 60 percent equity allocation. Stocks had become more attractive relative to bonds for the long term.

What should investors do today?

"Unless they've changed their investment horizon or their risk profile, they probably shouldn't make a whole lot of changes," Molitor says. "It's kind of silly to challenge the belief that over the long term -- if you're talking 15 to 20 years -- stocks would outperform bonds.

"Maybe there will be a few more bumps in the road. Earnings not coming out where people had hoped. A slowdown in the offing. Maybe we will, maybe we won't get a cut in interest rates from the Fed.

"Looking forward in terms of what really makes sense longer term is really the best policy."

Copyright © 2001 Werner Renberg. Reprinted with permission.

More articles by Werner Renberg can be found here.