Publications

Sage Advice from an Investment Sage

Dayton Business Journal - April 2007
Expert Advice Column by Kathleen A. Carlson

Liz Ann Sonders, Chief Investment Strategist for Charles Schwab & Company, was in town a couple weeks ago for the University of Dayton's International R.I.S.E. Symposium. Her advice, while instructional for the hundreds of students in attendance, served to remind the professionals about where we should focus our energies.

As expected, Sonders was peppered with questions about where to invest now, including what stocks to buy. She wouldn't take the bait. Instead, Sonders used the inquiries as an opportunity to discuss what factors drive investment performance. Citing an article from the Financial Analysts Journal, May - June 1991, titled "Determinants of Portfolio Performance II: An Update," she pointed out that as much as 90% of a portfolio's performance will be explained by its strategic asset allocation-dollars allocated to such asset classes as large stocks, small stocks, international stocks, bonds and cash, expressed in percentage terms. More diverse portfolios could also include gold, real estate and commodity investments. In other words, the overall portfolio allocation accounts for 90% of the return. This leaves only 10% to be explained by market timing, security selection and other factors. The numbers tell me I ought to be spending more of my time analyzing asset classes and determining whether they should be included in my portfolios and less time fretting about what stock to buy.

Of the remaining 10%, 4% of a portfolio's return is explained by market timing-actively underweighting or overweighting asset classes based on analyses of the markets. Security selection has also been shown to account for 4% of a portfolio's return. The remaining 2% is explained by any number of random events.

Sonders went on to describe "how time in the market is more important than timing the market." All investors would love to be in stocks when they are going up and out of them when they are going down. I once had a client who said, in all seriousness, "I'm not interested in owning any stocks that go down." Okay, I thought, I'll just give them to my clients who do. Needless to say, this person is no longer a client. While we've heard these numbers before, they bear repeating. The total return for the S&P 500 Index from January 1, 1997 to December 31, 2006 was 124%. If an investor missed being in the index on the 10 best days in those 10 years, their return would have been 40%. If they missed the top 40 they would have lost 48%. Mistakes in timing the stock market can be quite costly. It is extremely difficult to make up for a missed opportunity. Sonders' point is that market timing is more subtractive to investment performance than additive and advises against doing it.

Her avoidance of market timing goes so far as to mean no overweighting or underweighting of asset classes over a market cycle. She recommended developing an asset allocation that is reflective of your risk tolerance and time horizon and sticking with it.

Asked, given her bearish view on the housing market, does she recommend selling stocks now? Sonders answered, she lets her portfolio tell her when it is time to sell. For example, if her small stock allocation was 20% and it had grown to 25% because of its relative outperformance, she'd take some profits and reinvest the dollars into the asset class that had fallen below her designated allocation. Sonders recommends rebalancing portfolios on an annual basis.

So, if we can't time the market and investment selection only accounts for 4% of our total return, where should we be spending our time? It follows that we ought to broaden our understanding of the universe of possible asset classes and the risk, return and diversifying benefits to be gained by including them in a portfolio. Some additional classes to consider might include international stocks, commodities, real estate and below investment grade bonds. Finding appropriate investment vehicles in which to access them will also take some time.

While studying asset classes is not nearly as exciting as hunting for the next Google, according to an investment sage, it may be more rewarding.