Investing: Getting the Balance Right

The runup in stocks may prompt investors to wonder if they should rejigger their allocations. Here's what the pros think

By David Bogoslaw

One clear lesson investors have taken from the current financial crisis is that a buy-and-hold strategy is no longer a sure thing in a much more volatile and uncertain market environment.The growing popularity of tactical asset allocation within portfolios, using a broader palette of investment vehicles, is changing the way investment managers think about periodic portfolio rebalancing.

With the Standard & Poor's 500-stock index up 65% from its March lows, and the U.S. economy showing signs of modest improvement, investors who didn't flee equities are having to think long and hard about when and if to reduce their exposure. On the flip side, those who have sat out the rally are wondering if it's too late to jump in.

For those still focused on maximizing returns, adjusting asset allocations is no simple task given the multiyear low yields that U.S. Treasury bonds are paying.

The likelihood that the roller coaster in asset prices will continue into 2010 will challenge asset managers to be more dynamic in their allocation decisions, Alan Brown, group chief investment officer at Schroders, said at a Dec. 2 press briefing on his outlook for 2010.

Price-Earnings Caution

But he cautions against relying too heavily on price-to-earnings multiples to guide trading decisions since they aren't measured precisely enough. It's generally far too early to sell an asset the moment you think it's overvalued, and to buy it on the first sign of decline, he says.

"We want to see the right valuation together with a catalyst that would reverse the direction of an asset," such as the Federal Reserve ending its quantitative easing program, he says.

Given the unprecedented scale of the government liquidity programs in the U.S. and the United Kingdom that need to be unwound in the years ahead, Brown says "the range of possible outcomes may be wider than our imaginations." That calls for a more humble approach to setting out a market outlook for the next year, he says.

He advises people to develop scenarios for various possible outcomes and identify early warning signs to watch for in making allocation moves. For example, if you expect inflation to spike, you would keep an eye on commodity prices, the weakness of the dollar, or tightening labor markets.

The losses most investors suffered over the past year or more have caused a shift in priorities toward prudent risk management from the wild-eyed pursuit of returns that dominated asset allocation decisions before the financial crisis.

Rebalancing Discipline

When it comes to asset allocation, Brown says, "it pays to be broadly diversified and to be flexible and change allocations as [economic] events develop."

Discipline is also a virtue. PNC Wealth Management (PNC) thinks it wise to rebalance a portfolio whenever there's a 5% to 10% deviation from a targeted asset class weighting, for the sake of keeping transaction costs and tax consequences to a minimum. There's only a modest performance difference with rebalancing, but the reduction of risk is quite significant, according to a white paper PNC published in May 2009. PNC found that rebalancing a balanced portfolio once a year would have reduced the maximum decline experienced from 44% to 34% from 1979 through 2009.

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