Relax with a “Gone-Fishing” Portfolio

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Gone CruisingSummer is almost here. It’s time to go fishing or take a trip or do wherever else you enjoy while on vacation. Unless your interests lie in investment management or you have a trusted fiduciary watching over your investments, consider having a portfolio designed to allow you more time to relax.

A gone-fishing portfolio has a limited number of investments with a balanced asset allocation that should do well with dampened volatility. Its primary appeal is simplicity. But a secondary virtue is that it avoids the worst mistakes of the financial services industry.

The efficient market hypothesis suggests that individual stocks are correctly priced by the market until new information becomes public, moving stock prices so they are again correctly priced. Superior returns then are the product either of luck or of trading on insider information.

There are two notable exceptions. First, stocks with a low price-to-earnings ratio, so-called value stocks, generally outperform the others. Similarly, companies with a smaller total valuation generally outperform large-capitalization stocks such as those in the S&P 500. Thus small-cap value stocks generally show the best returns over long periods of time.

Critics of the efficient market hypothesis point to specific times when pricing in the markets turned out to be wildly incorrect. Or they cite specific investment managers who have consistently beaten the market over time. But after a while new information made the correct price obvious. And given enough managers picking stocks, some lucky pennies are bound to come up heads 100 times in a row.

Even if the markets aren’t perfectly efficient, they work well enough for you to reach your investment goals using all index funds.

Building wealth depends mostly on how much you save and invest. It also is closely associated with how early you start so your investment returns can compound for longer. The most important decision you make is how much to save early in your working career. Later in life, your most important investment decision is how you divide your assets among different asset categories.

Most investors mistakenly believe index investing is the same as putting their money in an S&P 500 fund, which consists of all U.S. large-cap stocks. We call that half an asset class. There are over 8,000 indexes. The S&P 500 is one of the many indexes we don’t recommend.

Imagine the S&P was a financial advisor. It would say, “Let’s buy mostly large-cap growth stocks in the industry that did well last year with a high price-per-earnings ratio.” In other words, the S&P 500 overweights large-cap growth rather than the more lucrative small-cap value. Having the right balance and mix of investment indexes is critical. Your investment gains will be directly related to the return of the asset allocation you select.

Your investment return will also be diminished by the expenses of running the specific investments you select to track your indexes. The lower the fees and expenses of the funds you use, the more of the investment return you get to keep. There is an additional drift because the fund you select does not perfectly track the target index.

These are the only factors determining your investment return. So you can follow a disciplined approach to building a portfolio of funds with low expenses with a target asset allocation that you rebalance back to annually or semiannually.

Rebalancing your portfolio provides a rebalancing bonus. The exact amount is proportional to the lack of correlation between the asset classes and the volatility of the markets.

Crestmont Research studied the difference in returns between rebalancing every year versus every two years in varying types of markets. In secular bull markets, rebalancing less frequently had a slight 0.3% annualized advantage. But in secular bear markets, rebalancing more frequently had a more significant 1.3% advantage. Another study of the same time period verified smaller gains for even more frequent quarterly and monthly rebalancing. And research on the Yale endowment attributed 1.6% of its annual portfolio returns to rebalancing.

Rebalancing can both reduce risk and boost returns. But you can’t rebalance your portfolio if you don’t have a target asset allocation to rebalance back to. That is part of the benefit of a gone-fishing portfolio over a buy-and-hold-and-grow-out-of-balance portfolio.

In other words, the genius of the gone-fishing portfolio is not only the time you can spend relaxing. It’s the boost in returns you get from setting your target allocation and rebalancing annually or semiannually. Annual rebalancing is close to optimum. Twice a year, in May and September, is also excellent. Whenever the market is in the news for reaching new highs or lows is appropriate too.

So set your target asset allocation according to your age and situation, and rebalance on a regular basis.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)