Friday's column
advocated self-awareness. The stock market's movements seem to be
meaningful, but their signals are spurious. Therefore, investment wisdom
consists of learning to avoid the temptation to trade. The investor who
acknowledges his ignorance is better off than the investor who does
not.
A reader, Marvin Menzin, noticed. "Your advice implies that investors
should buy and blithely hold. It ignores the possibility they might want
to reduce your exposure because of excess stock-market valuations. I
think it would be an excellent column if you were to address when
investors should rebalance to lower-risk portfolios, especially when
it's a retirement account and taxes are not germane. Investors are told
to stay the course. The Titanic stayed the course!"
Well, Mr. Menzin, this is that column. Although I must confess, the
"when" is exceedingly rare. Since World War II, I can think of only one
clear and obvious occasion when U.S. stock investors should have
reduced their exposure.
To start: A portfolio's stock position should indeed be traded
regularly, through mechanical rebalancing. If stocks perform well, such
that a portfolio that was initially 60% stock/40% bonds becomes 70/30,
then it's logical to return to the original allocation. After all,
nothing changed from the initial decision.
Rebalancing, however, is more easily said than done, because while
maintaining a consistent asset allocation makes economic sense, it's not
much fun to implement. Selling winners feels good if stocks then
decline, but if they do not, the opportunity cost can sting. Worse yet
is the opposite situation. Mr. T had one word to describe how people feel after they buy equities when the headlines are urging otherwise, only to see stocks fall further. Pain indeed.
Thus, rebalancing is best done automatically: Establish a trading
rule; follow its instructions devoutly; and suffer no regret if the
transaction turns out badly. After all, the decision was the model's,
not yours.
Unfortunately, I do not see how mechanical processes can guide
investment strategies that are based on stock-market valuations. Those
who have tried--most famously by using the Shiller CAPE P/E Ratio,
which examines stocks' cyclically adjusted price/earnings ratios--have
failed. Such measures work well in hindsight, but they have not been
useful predictors. Their explanatory power has been academic rather than
actual.
Historical Assessments
For 20 years following the conclusion of World War II, there was no
judgment to be applied. Remaining in equities was the correct decision.
Then came 15 terrible years, through the mid-1980s, when the stocks were
devastated by inflation. For that stretch, investors would indeed have
done well to avoid equities. However, making that choice involved
understanding the economy, not judging the level of equity valuations.
It wasn't that stock prices were particularly steep. It was instead that
inflation spiked far higher than it had been, and also far higher than
it would become.
Since the early 1980s, stocks have crashed three times.
Two of those occasions, I believe, were almost impossible to anticipate.
Black Monday in 1987 came out of nowhere; even in hindsight, it is
difficult to understand why. The 2008 financial crisis, on the other
hand, happened for well-documented reasons. But once again, the
determinants were economic. Across the globe, banks collapsed and
housing markets sunk. No stock-market indicator could have anticipated
that.
The one occasion in which judgment served was during the "New Era," when
technology stocks posted valuations that still exceed all subsequent
levels. Sentiment was equally overheated. That truly was a time to slash
one's stock-market exposure. Even then, though, the timing needed to be
right. Those who sold equities in 1996 fared worse than those who
stayed the course and held through the worst of the downturn.
In short, Friday's column overstated its case. Sometimes stocks do cost too much. But recognizing when that situation arises, and profiting from the knowledge, is a severe task.
-- John Rekenthaler
