Don't Double Down on Stocks

 | May 28, 2013 | 11:00 AM EDT
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The market's volatility last week is an important reminder that investors must attune their investment portfolio to the possibility of good or bad times.

Successful investors will overwhelmingly attest to the importance of having a durable and a disciplined asset allocation: a defined split among stocks, bonds (or other fixed income securities) and cash.

Asset allocations should be all-weather determinations that reflect the following key investment considerations:

  1. The purpose of the money, and the time horizon for investing. Nest egg money carries different investing implications than tuition money to be spent over the next five years. Money that will not be needed for a long time should be more aggressively invested; near term money needs to be capital preservation-oriented.
  2. Your own tolerance for risk. No one wants to have staff meetings with themselves at three in the morning worrying about their portfolio. If that is happening, your asset allocations might not be reflecting your willingness to experience market volatility and fluctuations.
  3. Cash needs. If you are withdrawing from your investment portfolio in any regular or meaningful way, this fact needs to be reflected in your asset allocations.

Ideally, an asset allocation that accurately reflects the above criteria will not significantly change merely because of market conditions. If it does, it should change only incrementally and reflect a willingness to become more opportunistic about stocks in bear markets as well as more selective and skeptical about stocks after strong market increases.

Many investors might think that now is the time to double down on stocks, but we would counsel the opposite. This is a time to review and to respect your asset allocation and to remember why you have it.

For example, coming out of the volatility and defensiveness of 2011-- and to a lesser extent 2012 -- many investors reduced their exposure to stocks. Often, reducing stock exposure after a decline in hopes of avoiding additional losses turns out to be ill-timed.

Increasing that exposure to stocks now would probably be a mistake. You could be setting yourself up for a similar retreat during weakness if there is a market pullback. If you have had a tendency to reduce equity exposure during weak markets, now, from strength, is the right time to review your allocations and to consider reducing your equity exposure.

This need not be done in one fell swoop, but rather with an eye toward reducing your percentage in stocks by x% for every y% gain in your portfolio. This is dollar-cost averaging in reverse, but it enables you to sell into strength, and to be in a position to review your allocations again if the market pulls back.

There is a caveat to a possible reduction in equity exposure. In today's low-interest rate environment, the return potential in bonds is rather limited. In addition, the current income stream offered by any conservative bond is distressingly low. So understand that a reduction in equities represents more a right-sizing of your long- term risk profile, while increased bonds and cash over the foreseeable future is more geared to treading water and to balancing out the more volatile part of your portfolio.

This conundrum involving bonds has led many income oriented and volatility sensitive investors to embrace lower-volatility, higher-dividend stocks as an alternate mechanism to lower risk. While this strategy has been very successful in the past few years, it is important to remember that these, too, are stocks. We also expect them experience volatility and pullbacks. So, while this is an effective way to lessen overall equity risk, it is not foolproof nor failsafe.

The bottom line is that while it is counterintuitive to sell stocks during a bull market, the stock market works counterintuitively. It makes good sense to review your assets and lock in some profits if you are over weighted to stocks relative to your cash flow needs, time horizon and risk tolerance. This action will ultimately prove to have been a prudent and profitable exercise.

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