The last week of the market has been … disappointing … to put it mildly. With no great surprise, the families I serve are nervous. It’s a reasonable response. Well, that isn’t technically correct, it’s an expected response. When my car breaks down, I get nervous. I’m sure my mechanic doesn’t get nervous when his car breaks down. He probably rolls his eyes and thinks to himself, “How irritating.” My friends, family, and clients invariably ask, “Scott, is now the time to sell?” I appreciate that they think me smart enough to know the future of the market.
What does perplex me is the response that is coming from “industry experts”. I hear the sky is falling, it’s the end of the world, it’s a great time to buy, it’s a great time to sell, and it’s a great time to freak out and run around like a chicken with its head cut off.
Why the surprise? They should know better. The dirty secret is that knowing better and selling better rarely go hand in hand.
Think about the question, “Should I sell?” This question is predicated upon and implies knowledge of the future. No one (human anyway), absolutely no one, knows what the future holds. Anyone claiming something different is a liar, ignorant, delusional, and may be all three.
“Should I sell,” also suggests a level of fear. If you don’t have a plan, your fear is justified. If your current financial plan depends on your (or your advisors) ability to divine the future, your fear is well justified. If your plan DEPENDS on the market moving up and down in this manner, then you should just smile and move along.
WHAT?!!? I should smile and move along as the market crashes?!
How do I gain such a level of blissful detachment oh wise Maharishi?
Diversify and rebalance.
No problem Scott! I own medical, industrial, commercial, cyclical, equities, bonds, blah, blah, blah! Are your returns diversified?
I don’t know.
You should be afraid.
The idea of diversification is based upon the idea that returns are diversified. The value of diversifying returns doesn’t become apparent until you rebalance. Think of it like planting a seed. After you’ve planted the seed your job is not done. You have to water the seed. Diversification is the effort of planting. Rebalancing is akin to the constant maintenance and attention that must be given via watering.
Many of our families have investments that have risen during the market fall. They also have investments that have stayed flat. They also have investments that have fallen less and more than the market. When we rebalance their portfolios we will sell some investments high and buy others low.
Consider the following charts. They are made up of mutual funds. It doesn’t matter which mutual funds, that isn’t the point. We are trying to establish a visual understanding of diversification.
This portfolio’s1 returns are less diversified. We’ll call it Portfolio 1.
The following portfolio’s2 returns are fairly well diversified. We’ll call it Portfolio 2.
What if we fail to rebalance? Portfolio 1 is the portfolio that is less diversified. Portfolio 2 is our diversified portfolio.3
This chart illustrates that the two portfolios act relatively similarly if we don’t rebalance. The diversification didn’t do much (if anything) to help our returns.
What happens with these portfolios if we rebalance both of them annually?4
Now we can see the value of the diversification as the act of rebalancing helped us separate Portfolio 2 (more diversified) from Portfolio 1 (less diversified).
The true irony is the mathematical application of this strategy. If your returns are diversified and you rebalance, this will increase your returns and/or lower your standard deviation (risk). This reward isn’t a free lunch though. Referencing the seed analogy, this is the fruit of our labor.
In this sense, we welcome volatility. The volatility is the lemon in the lemonade. Certainly, no one wants to lose money and we would all like CD’s that give us 12% returns, but that isn’t the world we live in. I know someday the investments that are currently doing well will fall in value and vice versa. We will rebalance then too.
So, should you sell? Absolutely … if you are in the process of rebalancing.
If you (or your advisor) is soothsaying … then good luck.
If you aren’t sure whether you’re advisor is trying trying to be Nostradamus or not, reach out to us! We’re available via email at email@example.com or phone at 949-798- 5759!