Last year was an easy year to make money in stocks; when markets shoot straight up, it becomes trendy amongst retail investors to tout index investing. When stocks are up 30% in one year, who would argue that stock picking and sophisticated methods of allocating portfolios to asset classes, categories, and verticals can beat just dumping all of your cash in SPY and forgetting about it?
But when times get tough, the importance of asset allocation becomes much clearer. 2014 has not been a year of set it and forget it investing. The S&P 500 is down over a percent for the year so far as we get into the first earnings season for FY2014. While initial results from Alcoa (AA) and Wells Fargo (WFC) have been encouraging, that on its own hasn’t been enough to keep the optimism of 2013 going.
In times like this, there is a temptation to reallocate a portfolio towards a more defensive posture. For instance, investors who are down for the year might consider dumping tech stocks and going for bonds. Long-term Treasuries are outperforming; The 20+ year Treasury ETF (TLT) is up nearly 10% for 2014.
So, of course, a lot of less sophisticated investors are considering bonds now, which has prompted some mainstream media outlets to write in detail about bonds. This is a sharp reversal; bonds were a big underperformer in 2013, and many mainstream outlets dismissed the decades-long bond rally as essentially over as we began a rising rate environment.
Those keen investors who saw a bottom in bonds in late 2013 and who reallocated accordingly are now beating the market, but those are few and far between, at least judging by bond fund capital flows. Much more likely, a number of latecomers who have seen cratering declines in momentum growth stocks (P, TSLA, NFLX, TWTR) are more likely to panic and reallocate away from growth and into bonds or other lower-risk assets, like consumer staples or large-cap dividend yielders.
The problem with this reallocation is that it is likely to eat into returns and cause underperformance. If you held these momentum stocks for the first quarter of 2014 and eat losses now to buy into bonds, you are taking losses and buying after bonds have appreciated by nearly 10%.
Why would traders do this?
If they are honest with themselves, many do it because they are panicking and looking for safety. This is reactionary portfolio allocation—that is, identifying a change in the market after it has already played out and reallocating accordingly. This type of asset management is more driven by emotion than logic, and will inevitably yield a poor performance.
Much more desirable is the proactive allocation of assets. Those who saw a strong growth in stocks at the end of 2013 and decided it was time to take profits have already rotated into more defensive assets, and have captured that 10% increase in bond values while avoiding the negative return on SPY and the higher negative return on momentum stocks.
The problem is that few portfolio managers are nimble enough to make this switch before the market turns, even if they know intellectually that the market trend has changed. The fact is that it takes an agnostic approach towards assets and returns, which most people do not have. To make these outperforming returns by reallocating capital, these outperforming investors acknowledge that sometimes the market is kind to growth stocks, sometimes it’s kind to defensives, and sometimes it’s brutal to everyone. This runs counter to the more popular approach to investing that declares an end to a bond bull market (as was proclaimed in 2013), or an end to tech stocks (as was proclaimed in 2000), or an end to the U.S. economy itself (as was proclaimed in 2009).
This is the essence of Warren Buffett’s maxim to be greedy when others are fearful, and comes to the essence of value investing. Finding value where others do not is understanding that the market goes in cycles, markets do not suddenly end forever, and fear is a bad basis to make investment decisions.
At a time when stocks fall lower and lower just when many have proclaimed the virtue of passive index investing, understanding this basic concept is extremely valuable.