Wednesday, July 4, 2012

What About Europe?

It's old news that Europe has been having serious economic problems. How has this affected my investment strategy? The short answer is that it has not affected it at all. My investment strategy is not dependent on economic events. What has already happened is already reflected in stock prices. Current fears about what might happen also is already reflected in stock prices. Since I can't invest in the past, bad things that have already happened and have pushed stock prices lower have no impact on my investment strategy. Since I can't forecast the future (no one can), I have no special insight into what bad things may or may not happen, so I don't invest based on widely known information that causes many to fear that bad things will happen in the future (also already reflected in lower stock prices). This doesn't mean that I haven't made any changes in my portfolio as a result of the economic turmoil in Europe, concerns about slowing growth in China, etc. So what have I done and why?


One component of my investment strategy is to hold about 40% of my stock allocation in international stocks (i.e., non-US stocks). This is most easily done with something like the Vanguard Total International Stock Index fund, which is one of my international holdings. However, since I also like to slice and dice my portfolio, I also hold some funds that invest in specified subsets of the total international market (but when combined, pretty much add up to the total international market). Examples are developed markets (often referred to as EAFE, for Europe, Australasia and Far East), emerging markets, and international small-cap stocks. I also own  two funds that represent the two major components of developed international markets: Europe and Asia-Pacific.Vanguard offers mutual funds and ETFs for each of these subsets of the international market, as do many other financial institutions.

Although I have a general policy for rebalancing, which is to buy asset classes that are below my target allocation and sell asset classes that are above target, I don't have a firm policy for how much the asset class must deviate from target before rebalancing. An example of a firm policy would be to buy or sell the asset class if it deviates from target by five percentage points or more; e.g., buy international if it drops to 35% of my stock holdings. Another firm policy would be to simply rebalance once each year on a certain date.

Despite not having a firm policy, I have done some rebalancing by buying some more of my international funds and selling some of my US funds, most recently in May. I did this because I noticed that international was down about 20% relative to US over the last year, and I decided this was a big enough deviation to warrant rebalancing. I think my international allocation might have been down to something like 37% of stocks (vs. my target of 40%), and I rebalanced to re-establish my allocation to about 40% of stocks.

Although the primary purpose of rebalancing is to manage risk, there's also the possibility of a "rebalancing bonus"; i.e., a slight increase in total return by buying low and selling high. Stock prices fall because bad things have happened, or because there is fear that bad things will happen (or both). Therefore, the only way to get the rebalancing bonus is to buy more of an asset class  when there is concern and fear about that asset class (and sell some of an asset class that everyone is overly enthusiastic about). As Warren Buffet has said, buy when others are fearful and sell when others are greedy. Of course with rebalancing we're not talking about buying or selling our entire position in an asset class, but instead about making incremental changes.

So, rather than pay much attention to the financial news about Europe and other international economies, I pay more attention to how much European and other international stocks are up or down relative to US stocks, and whether or not there is a big enough difference to rebalance. I don't let financial news influence my investment decisions; instead, I stick to my investment strategy, which involves maintaining specified allocations to several asset classes. Everything I've learned about investing indicates that this is likely to generate superior long-term returns, but of course there are no guarantees.

When you invest in stocks, you get paid to take stock market risk (as opposed to the firm-specific risk of owning an individual stock, for which there is no expected risk premium). Well, you don't always get paid, but the expectation is that you will earn a higher return in the long run by investing in riskier asset classes; otherwise, very few would do so. So yes, there is more risk in Europe now than there has been at other times, and the depressed stock prices reflect the increased risk; that's what happens with risky assets. By sticking with my investment strategy, and maintaining a predetermined exposure to different subsets of stock market risk, I expect to earn a higher long-term return than if I were to buy and sell based on the latest financial news.

For investors who are saving and investing regularly, a good way to rebalance is to direct more new savings into asset classes that are below target, and less to asset classes that are above target. If you have a target allocation to international stocks, this means that you would have been putting more of your new savings into international stocks at various times over the last year or so. If you haven't done so, now might be time to review your asset allocation to determine if some rebalancing might be in order.

3 comments:

Marisa Moore said...

I'm really glad you wrote on this topic. I see so many people influenced by media when determining their next investment strategy. You have taught me well to jump for joy when the market is down, as this simply means another opportunity to buy when stocks are low. I have never once experienced the panic other people might feel when they hear how poorly European stocks are doing. Thank you for this valuable lesson, as I am confident this investment strategy will serve me quite well in my future!

Tom@206 said...

I try to rebalance once a year, at the beginning of the year. However I like this rebalance strategy for special circumstances.

beenthere said...

I like your philosophy, invest in what is low. I do that now with new money invested. I enjoy your blog.