Written By: Thomas M. Geier, CPA, CFP®, PFS
If you were to ask most investors for one word to describe their investment portfolio, you’d get a wide variety of answers. Many would echo the latest industry adjectives such as “long-term,” “growth,” “balanced,” or “diversified.” Others would reflect the current emotions of the latest stock market news, such as “gaining,” “advancing,” “recovering,” or maybe even “frustrating.”
I’d make the case that the most important term for your portfolio in today’s investment environment is flexibility. A flexible portfolio is one that is pliable. It can bend, adjust, and adapt to the considerable market pressures and forces that confront it.
To use an analogy, a boater who wants to get from one port to another can easily chart a path or course to follow. However, he also needs to consider other factors that may affect his trip, such as tides, wind, weather, and currents. Boaters must be very flexible and be able to adapt to unexpectedly changing circumstances. Simply starting the engine, pointing the boat in the right direction, and switching to auto pilot is not a smart plan. At worst, the boat sinks.
Likewise, an investor can set a reasonable goal for his or her portfolio. By considering the basic factors that will affect the results, such as time, risk, available investment choices, environment, and valuations, an achievable path can be set. But again, putting your portfolio on auto pilot is not necessarily the best choice. Changes may be needed, from small tweaks to more significant adjustments.
When to Be Flexible With Your Portfolio
How do you know when to be flexible and adapt? Boaters are continually finding ways to monitor conditions that will impact their course through GPS devices, depth finders, tide charts, weather apps, and radar reports. You, too, can monitor the major pressures that influence your portfolio.
For example, consider risk. Many investors perform an initial risk tolerance evaluation and are “one and done.” However, you would be surprised at how life events change your capacity for and perception of risk as time goes by. Analyze your risk factors at least every few years. Adjusting your portfolio for risk can have a significant ramification on the overall return and the level of stress you experience regarding it.
Valuations can also be monitored. We’ve all heard the adage “buy low and sell high.” But how do you put this into action? One way is to make adjustments to your investment choices based on their valuations. Just as normal tide levels can be determined by historical measurements, so can normalized investment valuations be measured.
One common measurement for equity valuations is the Price to Earnings ratio. I’d suggest using the Shiller PE or CAPE. Based on the chart below, you can see that the CAPE seemed to roam within a range of 10 to 20 for most of the last 114 years. It congregated around 15. Yes, there are some extreme outliers. Just as an unusually strong wind and a full moon can drive tides to abnormal extremes, so can acute market forces impact valuations.
Source: Yale University, Department of Economics
Assume you are a moderate investor with a typical equity/bond allocation of 60/40. You decide that, for your portfolio, you never want to have over 60% or less than 20% in stocks. Based on your risk preferences, you would like to mitigate against extreme equity drawdowns, if possible. A valuation strategy that may help achieve this could be to lower your equity portion by 10% for every percent that the CAPE goes over 20, stopping at your minimum of 20%. Once the CAPE falls back to 20 over time, add 5% for each 1% under 20 until you are back up to the 60% level.
Look at Market Environment
Market environment is another factor to examine, just as a boater must consider the weather. If a storm is approaching, the boater can decide to wait it out, tough it out, or steer around it, depending on the severity. Determine which major market elements could influence your portfolio and decide if any action is necessary.
For example, the Federal Reserve is in the process of tapering its Quantitative Easing program. Most industry observers believe this program has been a driving force for both equity prices and interest rates. What effect will the ending of this program have on your portfolio, especially bonds, if any? Again, there are many solutions available to moderate this event if deemed too detrimental to your portfolio.
Importance of a Flexible Portfolio
A well-constructed investment portfolio rarely needs a major overhaul. But, in my opinion, it must be flexible. Set an achievable goal and then monitor the major conditions that influence the outcome. Be pliable and adapt where necessary. Not only will you arrive where you want to go, but you’ll also enjoy the ride.
© Geier Asset Management, Inc. August 2014. Thomas M. Geier is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor. The above blog reflects the opinions of Mr. Geier and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance.