The Classics of Investing

Shakespeare and Mark Twain. Beethoven and the Beatles. Some things are timeless. Long after fads are forgotten, they are still recognized as classics. We turn to them because of their enduring value. Classics live on as successive generations continue to embrace them and the short-lived fashions of the moment are forgotten.

Diversification and investing time horizon. Dollar-cost averaging and rebalancing. Okay, so they may not be Huckleberry Finn or the Ninth Symphony, but these, too, are classics of their own kind. They are the durable investing practices that have withstood the tests of time. Through every economic and market condition, as investing crazes appeared and faded away, these investing classics have proven their value. They are the principles that generations of successful investors have used to reach their goals.

Yes, times have changed. Companies make cell phones instead of saddles. Information speeds over the Internet rather than being carried by messenger. More facts, figures and opinions about investing are more rapidly available to more people than ever before. Despite these dramatic economic and technological changes, the fundamentals of investing in the financial markets remain unchanged. Today’s markets still defy prediction, just as they always have. They remain volatile. They can surprise, bewilder and amaze even the experts.

This impossibility of predicting financial markets with confidence is the most basic truth of investing: there is and always will be investment risk. The investor’s dilemma is how to achieve needed return without excessive risk. Prudent retirement investors use investing classics to help manage inescapable market uncertainty.

Diversification

This is the starting point that most investors use to manage investment risk. Diversification is simply defined as “not putting all of your financial eggs in one basket.” Spreading your money among funds that have many different stocks and bonds and that use various approaches to investing will help even out the inevitable ups and downs of the financial markets over time. Diversifying your investments reduces the impact if one investment, or investment type, has big losses.

A few years ago some investment advisors and market commentators were telling investors to forget about diversification. Instead, they promoted the fad of the moment, to concentrate investments in just a few of the "right" things. Concentration is the opposite of diversification. A concentrated portfolio seeks big gains, but it risks big losses. True, if you were incredibly lucky you might concentrate in the just right investments at just the right times. The problem is that, although it is easy to look back and see exactly where a portfolio should have been invested, you don’t invest in the past. The decisions we make today are for the future, and the financial markets simply don’t reveal themselves ahead of time.

Time Horizon

A common way that investors look at investment risk is the chance that the value of their investments will go down. We know that many investments, especially those in stocks or stock funds, are unpredictable, especially in the short run. This unpredictability means that your investment horizon, or time frame, is one of the most critical elements of your investing decisions.

While the stock market fluctuates dramatically on a short term basis, historically the longer a diversified stock portfolio was held, the lower the risk of loss. Going back to 1926, the S&P 500 large company stock index has had a single year return as good as a 54 percent gain, and as bad as a 43.3 percent loss. That is a lot of uncertainty. Measured over 20 year periods, the index’s average return was always positive, ranging from a 17.9 percent gain to a 3.1 percent gain. So, even the very worst 20-year period since 1926, a time that includes the Great Depression, the index has always been up. Patience pays off.

Your target date, that is, when you will need the money, helps tell you how much risk you can afford. If you are investing for your retirement that is still 20 years away, your investments have plenty of time to recover from any short term losses that may occur, riding out the inevitable ups and downs of financial markets. Later, when you are closer to the time when you will be needing the money, your investments may not have time to recover from a market slump. A shorter time horizon means that your investments should be exposed to less risk as you get closer to your target date.

Dollar-cost Averaging*

By investing a pre-determined amount at regular intervals, regardless of what the market does, over the years this consistency might actually turn market volatility to your advantage. As the market goes up, and the price of your investment portfolio is up, dollar-cost averaging means that fewer shares are purchased with the same contribution. When the price falls, more shares are purchased. Over time, this system tends to reduce the average cost of your shares. It is a simple way to get a bargain: buy more at low prices, fewer at high prices.

Dollar-cost averaging is especially important when you are investing in more volatile investments, such as stock funds. As the example below shows, regularly investing $600 a month as the price of the portfolio fluctuates between $20 and $40 as shown over four months, the price of the shares averaged $28.50 while the cost paid was $26.67.

Dollar-cost averaging is not a short term strategy, nor does it protect the value of your investments if their value goes down, as stock investments fluctuate over time. But it does mean that new contributions that you make when prices are low will recover as the investment value goes up again, as you expect it to over time.

Chances are that you are already taking advantage of this classic. If you are making regular dollar amount contributions to your retirement plan, and not changing the investment mix as the markets go up and down, you are dollar-cost averaging.

Rebalancing

If a diversified portfolio is held for many years, the normal changes of the markets will inevitably shift the mix of assets away from their original allocation.

To illustrate, let’s say that you began 1984 with a portfolio that reflected your risk level with an allocation of half U.S. stock funds (both large and small companies) and half U.S. government bond funds. If you did nothing at all to change your investment mix, by the end of 1994 market conditions had altered this mix so that 58 percent of your portfolio was in stock funds, and by the end of 1999 the Bull Market had unbalanced your asset mix so that a whopping 78 percent was in stocks. Even after the markets had begun to correct, you still had 72 percent in stock at the end of 2004. Instead of moving to a less aggressive asset mix as your target date approached, your portfolio had become far riskier than you intended. The solution to this normal asset drift is to regularly rebalance your portfolio, reestablishing your intended allocation.

Rebalancing at least annually does more than keeping your portfolio risk under control. It means that you are realizing gains from those funds or asset classes that have gone up the most, reinvesting profits into funds that have gone up less, or perhaps even have declined. Buy low, sell high. It is always the investor’s hope. Rebalancing makes it a reality, automatically.

* Dollar cost averaging does not assure profit. Plans do not protect against loss in a declining market. Since dollar cost averaging involves continuous investing, regardless of fluctuating prices, investors must consider financial ability to continue to invest during low price levels.