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Unconventional Investment Wisdom

04/20/2023 - Effective Saving, Financial Planners, Financial Wellness & Life Planning, Investing for Life

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To make investing seem easier, a number of “rules of thumb” have evolved over the years. Such rules have a basis in experience, but they tend to oversimplify the dynamics and challenges of sound portfolio management. Here are some examples.

The older you are, the more bonds you should own. The conventional wisdom once held that one’s allocation to stocks should be 100 minus one’s age. For example, the 30-year-old investor should have 70% exposure to stocks, while the 80-year-old would have only 20% in stocks. The idea was that while stocks outperform in the long run, their prices are quite volatile in the short run. Young investors have time on their side to outlast market downturns, and older investors do not.

Unconventional wisdom. Life expectancies have grown steadily longer since that rule was formulated, suggesting that shifting from stocks to bonds should be more gradual. In a period of ultralow interest rates, as we had in the period from the Great Recession to the pandemic, bonds present risks not accounted for in the original rule. Any increase in interest rates reduces the value of existing bond holdings, which will be costly if the bonds have to be sold before maturity. Finally, during periods of high inflation the income from bonds is not likely to keep up with the rising cost of living.

Retirees who have their routine expenses covered by Social Security and pension benefits can afford to devote a larger percentage of their portfolio to stocks.

Portfolios need rebalancing. The goal of every investor is to buy low and sell high, that is the formula for profit. Portfolio rebalancing is a disciplined way to achieve that end. As successful investments become more dominant in a portfolio, they are sold at their highs and the proceeds can be reinvested in the lower-priced underperformers. If a portfolio is designed to have 60% stocks and 40% bonds, during some periods the stocks may grow to 70% or more of the portfolio. While this is welcome, it also means that the portfolio has become riskier than intended. Rebalancing cures that.

Unconventional wisdom. Although rebalancing may lower investment risk, it does so at the cost of total portfolio return. In times of abnormally low interest rates, selling stocks to buy bonds may not decrease portfolio risk all that much, and the bonds will provide very little income. Selling winners to buy more losers assumes that all investments become average over time. Market history suggests that is not always the case.

Invest through dollar cost averaging. Warren Buffett’s mentor, Benjamin Graham, recommended investing a specific dollar amount over time, rather than a large amount all at once. This approach avoids the misfortune of a purchase at the top of the market. When prices are low more shares are purchased, and fewer shares are bought when prices rise. The market’s natural volatility is tamed with such a strategy. This approach is taken automatically by participants in a 401(k) or similar salary deferral retirement plan, in which a portion of every paycheck is invested in the plan.

Unconventional wisdom. In a 2019 report, Morningstar evaluated dollar cost averaging against immediate investment of a lump sum for ten-year periods going back to 1926. The immediate investment provided superior returns 90% of the time, because the general trend of stock prices has been up and the sooner one invests the sooner the magic of compounding can begin. The exceptions, when dollar cost averaging was superior, were the beginnings of bear markets.

Dollar cost averaging can reduce investment anxiety, but the price may be a somewhat lower total return.

Harvest your tax losses. During bear markets, investors may be encouraged to realize losses to offset investment gains. They may purchase similar (but not identical) securities to keep the overall portfolio profile largely unchanged. Up to $3,000 of capital losses may be deducted against ordinary income.

Unconventional wisdom. Care must be taken to avoid the trap of the “wash sale” rules. If the same security is purchased within 30 days before or after the sale, the loss is not allowed. New purchases will have a lower tax basis, and so may lead to higher taxes later. The strategy may work best for those who plan to leave the new assets to heirs or to charity, thus avoiding additional taxes on capital gains.

Content is for informational purposes only and is not intended to provide legal or financial advice. The views and opinions expressed do not necessarily represent the views and opinions of WesBanco.

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