In the portfolio implementation process, we place much focus on aligning the construction of the investor’s portfolio with his or her individual goals and time horizon. Conceptually, goals are easy to comprehend, even if translating them to quantifiable targets may sometimes present a challenge. The comparatively murky concept of investment time horizon can be a little more difficult to absorb. When fully embraced by the investor, the proper alignment of investment time horizon with portfolio structure should alleviate much of the concern that arises from short-term market volatility.
For maximum effectiveness, it may be helpful to view one’s investment time horizon as a lockbox. In part, the investor’s time horizon represents the anticipated future point at which the portfolio will be needed to fund an expected liability or become an active source of cash flow. It should also represent the duration of time that the investor could feel comfortable putting the invested funds into a lockbox – making them in essence untouchable – disregarding short-term market volatility in the interim from a strategic allocation viewpoint. Put simply, whether the market rises or falls, the investor should not need to modify their strategic asset allocation during that time.
We should note that the very remote possibility that some catastrophic event could permanently alter the global economic or investment climate could justify a material change to one’s asset allocation. In such extreme circumstances, such a decision could be rational. However, such a situation would be hard to envision. Even during periods of historically significant regional or global uncertainty such as war, terrorist incidents, or financial instability, the long-term fundamental underpinnings of the global economy have generally remained unchanged. In substantially all situations, absent a change in investor goals or material changes to their financial circumstances, the core decision of allocation between stocks and bonds should remain unaffected.
Of course, this does not take periodic rebalancing or tactical reallocations off the table. The potential benefits of those types of moves still exist. Rebalancing is the rational reaction to market volatility; modification of strategic allocations as a result of fear or greed is the irrational reaction to the same stimulus. Throughout both strong and weak periods in the market, investors must choose to react rationally or irrationally to volatility.
The volatility of the stock markets through much of 2004 provided little positive news for investors through the first nine months, before stocks finished the year with a two-month flurry that accounted for much of their returns for the year. The New Year, however, was not as kind to equity investors. Stocks stumbled out of the gates, suggesting that some investors may have been simply waiting to harvest recent gains to defer the tax consequences into 2005. While the market recovered some of its loss and partially retraced its steps in the closing week of January, monthly returns were still uniformly negative across the major stock indices. The S&P 500 Index lost 2.4% for the month, trailed closely by the 2.5% decline posted by the Russell Mid Cap Index. Small companies took the brunt of the sell off with the Russell 2000 Index surrendering 4.2%. International stocks held up better than their domestic counterparts, with the EAFE Index slipping 1.8%.
Fixed income returns, especially those on the short end of the yield curve, continue to be under pressure from rising interest rates. The Lehman Aggregate Bond Index Composite gained 0.6% for the month. On the short end of the curve, the Lehman Aggregate 1-3 Year Government index finished the month essentially where it began, losing less than 0.1%. Municipal issues posted minimal losses as both the 3-year and 5-year Lehman Municipal indices dropped less than a quarter point. As on the equity side, the international bond markets set the pace for the category with a 0.9% gain for the month.
While we report to you monthly on the returns of the market, for most investors the short-term upward and downward movements are irrelevant to their long-term success or failure. If a typical investment time horizon were measured by weeks and months rather than years, these returns would be much more meaningful. Further, a sound investment strategy for an investor with such a brief time horizon would likely be intriguing only in its simplicity. In the short-term, cash or cash equivalents rule the day and provide inexpensive liquidity. Over longer periods, the opportunity cost of longer duration bonds and higher risk equity investments increase. In the short term, the intermittent rise and fall of the market should be viewed as an opportunity to rationally rebalance. From a strategic allocation standpoint, however, volatility is best ignored by keeping one’s eyes on the horizon. When that point on the horizon has been reached, historical volatility viewed in the rear-view mirror should look like a mere bump in the road, not a roadblock to the achievement of one’s goals.
