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Managing Risk With Asset Allocation

But Stay Invested in the Market

When the market is choppy, your natural inclination is to shake up your portfolio. But this generally isn’t the best way to improve your returns or overall portfolio quality.

Assuming you have a well-thought-out asset allocation plan in place and you’re invested in low-cost, high-quality funds, it’s best to sit tight and not make a lot of changes. But resisting the urge to act is difficult, says Brad Levin, a Certified Financial Planner and president of Legacy Wealth Partners in Encino, Calif.
“A falling market plays to people’s emotions — generally fear — and they want to get out of the market,” he says. “By the time they decide it’s safe to get back in, the market is significantly higher and they’ve missed a good deal of appreciation.”
Also, by the time most people act, the market has already fallen and the damage has been done, says Michael Edesess, Ph.D., author of The Big Investment Lie (Berrett-Koehler Publishers, 2007).
“You must realize that the market isn’t falling — not in the sense that there’s a trend that’s predictable,” he says. “Rather, the market has already fallen. You can’t do anything about that.”
The rear-view mirror view distracts many investors, agrees Greg Woodard, a portfolio strategist with Manning & Napier Advisors. “As soon as there’s blood in the streets, you start worrying, and it’s tempting to throw in the towel and get out of the market,” he says. “But generally, when things look the worst, it’s the best time to get in and take advantage of what the market is giving you.”
It’s futile for long-term investors to speculate where the market will go in the short term. Standing firm with a well-crafted plan for asset allocation and pruning positions that are either overvalued or with deteriorating fundamentals will serve you better than having a knee-jerk reaction to a declining market.

Asset Allocation Fundamentals
Asset allocation is the practice of splitting investable assets among a number of different types of securities in an effort to limit risk. At the extreme, parishioners of asset allocation slice and dice their assets into numerous categories per the recommendations of gurus such as William Bernstein, author of The Intelligent Asset Allocator (McGraw-Hill, 2000).
Bernstein advocates the use of index funds to populate a portfolio, arguing that active mutual fund managers can’t beat the market over the long term. Others believe that judicious use of actively managed funds can enhance a portfolio, especially funds for sectors in which markets are less efficient. Small-cap and foreign stock funds in particular lend themselves to an active approach; studies have shown that active managers beat the indexes more often in these areas than in others.
Some purists believe the asset allocation decision itself is far more important than the particular stocks and fund held. But it’s hard to believe you’ll meet your goals by investing in poorly performing securities, even if you get the asset allocation right. (Further, some people believe asset allocation is an attempt to time the market and might be a way for portfolio managers to increase transactions.)

Setting Allocation Parameters
For most investors, a middle-of-the-road approach works best. “An individual’s asset allocation should be set based on the individual’s needs, not based on recent market movements,” says Bill Keller, investment director for PNC Wealth Management in Baltimore and Washington, D.C. “A plan needs to be in place to get individuals through these tough stretches.
“The logic goes like this: An asset allocation will determine the amount of return a person will generate over a period of time. The amount of return a person can expect is determined by the level of risk he can tolerate. Risk is determined by the client’s needs for the assets — how much liquidity is needed, the time frame of cash needs, the tax situation and whether there are any unique situations on the horizon.”
Generally, you want to divide your portfolio into several major asset classes, then subdivide from there. Most portfolios are well-served by a hefty portion of stocks or stock funds to provide needed growth. That growth helps investors overcome the effects of inflation and taxes.

The Biggest Danger
The biggest risk in changing your asset allocation in response to a falling market is getting out of the stock market altogether. The fear of loss drives many investors to do this, says Darrin Farrow, president of Pension Builders & Consultants in Westlake, Ohio. “If you aren’t in the market for the long haul, you shouldn’t be in at all,” he says. “Focusing on the next six months or the next year is too short of a time frame, but many of us do that because we’re an immediate gratification society. Our fear and our greed challenge us on a daily basis.”
For investors who get out of the stock market when it seems as if securities prices are going to continue falling, the trick is getting back in at the right time. But very few investors successfully time the market.
Levin of Legacy Wealth Partners notes that from 1926 to 2006, the S&P 500 index had an average annual return of 12.5 percent. Over these 80 years, there were 23 down years in which the decline averaged 12.6 percent.
But in the year after a decline — the recovery years — the market’s average gain was 28.6 percent.
The same general trend holds for a balanced portfolio of 60-percent stock funds and 40-percent bond funds, Levin says. The portfolio’s average gain during the 80 years was 9.9 percent. The average loss during the down years was 6.9 percent, and the gain during the recovery years averaged 18.8 percent.

Periodic Rebalancing
Rebalancing is the practice of periodically adjusting asset allocation. The idea is that over time, the percentages you allocate to various asset classes rise or fall based on the direction of the markets in which you’re invested. Whether you set strict allocation targets or more flexible ones, you’ll examine your portfolio occasionally and reallocate assets to keep your portfolio in balance.
For example, if you adhere to the balanced portfolio Levin mentions, your target allocation would be 60 percent in stocks or stock funds and 40 percent in bonds or bond funds. Over time, the stock allocation might drift upward when the stock market is performing well to, say, 65-percent stocks. In this case, you would sell 5 percent of the stock assets and reinvest them in bond assets to correct your allocation.
Rebalancing has the added benefit of transferring assets from the higher-priced funds into the lower-priced ones, which reduces your overall risk profile. In some cases, applying a commonsense approach to your portfolio of moving out of overpriced assets and into underpriced ones will achieve nearly the same result, says Woodward of Manning & Napier Advisors.
“Our bottom-up fundamental research approach is finding more bargains in equities,” Woodward says, “so we’re allocating more of our balanced funds to stocks and less
to bonds.
“And say we get into a situation like in 1999 or 2000, where equities are all hitting our sell targets and are overvalued, then we would replace those equities with fixed income. We’re not trying to be smarter than the markets but will put money into stocks if those present a better risk-reward profile and will put money into bonds if those look better.”

DODGX Reopens
In early February, the Dodge & Cox Stock Fund reopened to new investors. The fund, which had been closed since 2004, is a popular holding among readers. See the March issue for more information on the fund.

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