Monday Morning Jumpstart with Dan Richards

10 minutes to drive your week

Topic for June 15, 2009: Bringing strict discipline to your portfolio

Listen to the interview

1. A recent article in the Report on Business explored why so few investors can point to a track record of consistent success. Peter Lynch of Fidelity, who turned in a phenomenal annual return of 29% from 1977 to 1990, ha said that he never ceased to be puzzled by the extent to which the investors who owned his funds had dramatically lower returns than the funds themselves.
2. The answer lies in investors' and advisors' emotional reactions to market movements, creating an impulse to buy and sell at exactly the wrong times. In the words of Walt Kelly's 1950s cartoon character Pogo: "We have met the enemy and he is us."

3. Warren Buffett has been quoted that his big advantage doesn't stem from superior intellect or better information, but rather the discipline to dispassionately stick to his investment principles, no matter how difficult that might be

   In a column in the New York Times last October in which he announced that he was switching from US Government bonds to stocks for his personal account, Buffett summarized his investment philosophy: "Be fearful when others are greedy and be greedy when others are fearful."

4. Buffett's emotionless approach to investing is next to impossible for the average investor to replicate. The good news is that our innate discipline doesn't have to be up to Warren Buffett's standards for us to succeed as investors. Rather, we can artificially inject discipline into our portfolios by borrowing two simple tools from successful pension plans – developing a detailed Investment Policy Statement or IPS and regular rebalancing.

5. The investment policy statement factors in the return required to hit each investor's long term goals and his or her tolerance for risk to identify a target allocation between stocks, bonds and cash.

   Let's suppose an investor needs a return of 7% over the next twenty years to meet his retirement objectives. To achieve that, the IPS might stipulate a target allocation of 60% equities, 30% bonds and 10% cash, assuming returns over that period of 9% on stocks, 5% on bonds and 2% on cash, in line with historical experience.

   The IPS could also set a range around that target allocation – so depending on how an advisor and her client feel sabout valuation and risk levels, at any given time stocks might represent 50% to 70%, bonds 20% to 40% and cash 5% to 15%.

   By creating a range for each asset class, you impose a level of discipline that most investors would be unable to achieve on their own. In this example, no matter how optimistic you might be your stock component would never be higher than 70%, no matter how fearful it would never fall below 50%.

6. Once you've set your target allocation, the next step is to stick to it – and the way you do this is by automatically rebalancing your asset mix once or twice a year.

   At every given point in time, some asset classes always do better than others – in cases like last year, dramatically so. As a result, your asset mix gets out of kilter and needs to be readjusted.

   Let's say stocks were 60% of your portfolio on July 1 of last year. Because of the extraordinary events of the last half of 2008, in which stocks plummeted while Government bonds gained value, by December 31 your stock weighting would typically have fallen to well under 40%.

   At that point most investors' fear impulse kicked in – while they might have been prepared to in existing holdings, they could never have brought themselves to reduce the bond and cash positions that had done so well and heavy up their stock weighting. And yet that's exactly what investors committed to automatic rebalancing would have done. Because their stock weighting was below the minimum threshold of 50% that they had set, they had no choice but to go against every impulse and lighten up on the winning asset classes in their portfolio, in this instance bonds and cash, and buy more of the loser, stocks.

7. It's too early to know whether investors who did that on January 1 will be rewarded in the near term. But we do know a policy of consistently buying those asset classes that are beaten down and selling those that have had the winds at their back has paid dividends over time.

   We're unlikely to ever achieve Warren Buffett's fame, but by rigourously setting asset mix ranges and using regular rebalancing to stay within those ranges, we can bring some of his discipline to bear on our portfolio.