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It certainly has been a wild the year in the stock market so far. By the end of February, the market was ahead by 3 percent and we were off to a great beginning. Everything was looking rosy. The Dow Jones industrial averages had made a new high and the Standard & Poor’s 500 reached a six-year high. A lot of this was fueled by the Federal Reserves Chairman Ben S. Bernanke’s comments suggesting inflation was under control and that he was comfortable with the levels of interest rates. Then the March housing report was released. In just a few short weeks, the markets fell by almost 6 percent. In that short of a period sentiment had turned decidedly bearish. The housing boom was over. Just when the negative reporting in the financial press was at the worst the market started a long climb. By mid-July the market had appreciated 13 percent from the March lows and everything was looking great again. Then we ran into the proverbial brick wall. The hedge-fund crisis, the mortgage-lender crisis, the subprime-loan crisis, and the liquidity crunch all hit within a three-week time span. The broad market fell by 9.5 percent in less than a month. Every newspaper, every television show, every radio show and every Internet blog was screaming about the contagion spreading to the international financial markets. Rumors were flying about troubles at Goldman Sachs, Bear Sterns and dozens of others. That was the low point; when pessimism was raging, you should have bought. Since then the markets have climbed back to be within striking distance of new all-time highs. How did most individual investors react to each of these events? Well, like they historically have. They sold on the bad news, and they bought on the good news. Now that the markets are back near the highs we almost have a buying panic. People are acting in a way that is exactly the opposite of what a rational investor should be doing. Their fears and emotions are overcoming their common sense. This behavior has happened repeatedly in the stock markets. Just before the crash in 1987, when the market was really frothy, the average mutual fund investor had 28 percent of his assets invested in equities. Just after the crash, when the prices were at the best levels in years, they had 21 percent of their assets invested in equities. In reaction to the falling prices, and better values, they sold. This is human nature. Fear often overwhelms common sense at exactly the wrong moment. What can we do to prevent this type of behavior? How do professional investors prevent themselves from getting trapped in these types of situations? Well, the answer is that all of them don’t. But, the very best ones have a strategy to deal with this type of occurrence. Yale University has had one of the most, if not the most, successful endowment investing programs over the last two decades. Since being run by David Swensen this endowment has earned compound investing returns in excess of 16 percent per year. That type of performance in a fund of this size is spectacular. What does he do that is different from other investors that contribute to this type of unparalleled success? He acts like a rational human being. He buys when prices go down, and sells when prices go up. In other words, they actively rebalance their portfolio by buying low and selling high. In Swensen’s book Unconventional Success he tells a rebalancing story about their efforts during the markets gyrations of 2003. This was a market that looked very much like the market we have been experiencing this year. There was tremendous volatility; large rallies to higher prices were followed by the elevator drops on the downside. At the end of their fiscal year the market was only ahead by 1.3 percent. Yale University, however, had earned an additional 1.6 percent return from their equity portfolio by aggressively rebalancing at every opportunity. The swings in the markets that caused regular investors so much angst were viewed as investment opportunities to the professionals at Yale. Here are the basics of this strategy. An investor generally starts out with a portfolio that is designed to achieve their goals. It has an appropriate mix of assets classes for their goals, much like a foundations. The passage of time causes the relative performance of different asset classes to move this portfolio away from its initial allocation. Riskier asset classes tend to have higher growth rates and will eventually grow in value to dominate a portfolio. As time passes riskier assets grow to become a much higher percentage than was called for in the initial allocation. When this happens it also increases the portfolios overall risk. The way to control this risk, and maintain your asset allocation, is to periodically rebalance your portfolio. Sell the assets that have grown above their targeted allocation back to where they belong. The proceeds from this sale can then be put back into assets that are underrepresented in your portfolio. This disciplined maintenance of your designed asset allocation reduces risks and occasionally earns additional returns. This is the core strategy employed by Yale University. Say, for example, starting in 2002 you invested in a portfolio that was half stocks and half bonds. Over the last five years the relative superior performance of stocks would have caused the portfolio to now have over 60 percent in equities. This is 20 percent more equity exposure than the 50 percent you were originally comfortable with. The market has taken control of your asset allocation and your portfolio has become increasingly risky. If you had periodically rebalanced this portfolio your asset allocation would have remained constant. How much does this rebalancing cost? Since you were selling the higher performing assets you would think that rebalancing would dramatically reduce the returns. That is not the case. Every dollar invested in the original 50-50 portfolio, and left to grow as it may, would have grown to $1.46 over this five-year period. Every dollar in the portfolio that was rebalanced, at the end of each year, would have grown to $1.43. This is an insignificant difference in return for a substantial reduction in risk. Over very long periods of time allocations that are never rebalanced can become extremely risky. In fact, it is often common for long-term investors to have portfolios that are 80 to 90 percent equity. After most 20-year periods returns from equities start to overwhelm the returns from bonds unless the portfolio is periodically rebalanced. Often this increased equity exposure, and risk, comes during retirement when investors can least afford it. If institutions do this with such great success, and it is so easy to accomplish, why don’t more individuals rebalance? Well, it’s generally either because of investor psychology or fear of taxes. Just by observing the stock market activity from this year we can see that investor’s exhibit herd mentality. They like to buy when stocks go up and sell when stocks go down. Investors should do just the opposite but it is very difficult psychologically to act against the crowd unless you have a method. One way to prevent this herding behavior to set up rebalancing rules and follow them. Having defined rules about when to rebalance will force you to act even when your instincts are telling you not to. These rules can vary from the simple to the complex. Simple rules, like rebalancing once a quarter or once a year, can be very effective, particularly in tax-deferred accounts. This is because most tax-deferred accounts, such as IRA’s and 401(k)s, have very low transaction costs and no immediate tax consequences from trading. These types of accounts are ideal for periodic rebalancing strategies. Rebalancing of taxable accounts adds an element of complexity to the process. Instead of using a preset schedule rebalancing these accounts is generally done as a rules-based transaction. For example, a rule saying you will rebalance when your allocation moves by 20 percent � or more, subject to capital-gain constraints � takes effort to monitor. First, you need to periodically check to see how much your various asset classes have grown. Then you need to see if you’ve held the assets long enough for the preferential capital gains tax rate to apply. This is a very important point in rebalancing taxable accounts. You need to weigh the advantages of rebalancing, with the costs of paying taxes. Individuals generally let their portfolios grow from their targeted allocations because they hate the idea of paying taxes. They seldom realize that this is at the cost of greater investment risk. This tax deferral needs to be balanced out by the extra risk they take on by having more equity exposure. While we all hate to pay taxes, you occasionally need to pay some to keep risk under control. As we’ve seen in periods of market turmoil, rebalancing can add returns to your portfolio. However, over the long run, it’s more about controlling your risk than earning additional returns. The choppier the market, the better rebalancing works. Take a lesson from the pros at Yale. Buy what is out of favor, sell what’s popular, and don’t agonize over market fluctuations. Markets always fluctuate, so learn to take advantage of them. WILLIAM Z. SUPLEE IV is the president of Structured Asset Management Inc., a financial planning and investment advisory firm located in Paoli, Pa. He may be reached at 610-648-0700 or [email protected] .

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