Six months ago everyone expected a 10% market decline. The stock market hasn’t had a down year in the past five. We have been lulled by the market’s low volatility and the complacency around the world’s problems. So, all of a sudden we wake up and wonder if we should sell stocks. Geopolitical risks are bubbling up, energy prices are lower, the spread of Ebola is a fear and economic numbers are mixed. Should you sell stocks? It depends.
We all talk about the importance of asset allocation but do we practice what we preach? It is all too common to adopt the “glide” approach to allocating assets; we let our stock portfolios glide higher with a strong market, increasing our target allocation to stocks and convincing ourselves that we really can stand more risk. Stocks glide higher, we feel good and the better we feel the easier it is to justify more stocks. Out of nowhere comes a market drop – less today than the 10% we’ve expected – in reaction to what is going on around the world. It’s easy to dismiss the first signs of a market decline but if lower prices persist the common reaction is to want to sell stocks. As the portfolio glides lower, we reduce our stock target, convincing ourselves that we are in for a major market decline. We glide higher with the market, react as it turns down and glide down with it, selling out of fear. This asset allocation strategy leads to confusion and fear. We react emotionally to stock prices without paying attention to company fundamentals.
The “glide” approach to asset allocation doesn’t work. We miss the good days in the market – those valuable turns higher after a decline. If we get out of stocks in time we are often afraid to get back in. So what is the alternative? The most effective long-term approach to asset allocation is to set a long term target for each asset class and routinely assess the portfolio weight vs. target for all asset classes, including stocks. This forces one of two things; we either rebalance the portfolio to the target or substantiate reasons for variance. We look at stocks in relation to other asset classes. If we “glide” higher in stocks with the market it will be a conscious and well thought out decision, not a reaction to feeling good over higher stock prices. We will eventually rebalance. Yes, this disciplined approach may cause us to act too soon, but it’s better to be early than wrong.
What do we do now that the market has turned lower? If we paid attention to our target asset mixes we would have trimmed stocks as the market moved higher. We would have some cash and bonds that we could sell to add to stocks as a declining market takes the percentage in stocks below target. If we really expected a 10% market pull-back, did we stay at our near our target stock weight? The answer to the question – what to do now – is easier to answer if we haven’t let our stocks glide higher with the market. Today’s stock market is reasonably valued – about 16.8 times earnings – and not overpriced like it was in periods before the 2000 and 2008 market declines. If we have some cash and short-term bonds we can take advantage of stock moves down and add to attractive holdings.