In most of the country this week, people are shivering under a cold spell, which sent temperatures plummeting and dumped snow across a large swath of the Midwest and Northeast. If you’re craving heat, look no further than the post-election stock market, where an outlook of increased fiscal stimulus spending and reduced government regulation is driving plenty of energy.
But keep in mind the expression “buy the election, sell the inauguration.” As proven several times in history, when the market spikes after a presidential election, the following year tends to see some degree of a slide.
Most people maintain the largest portion of their savings in their employer’s 401(k) plan. Since 401(k) plans are a retirement savings vehicle, most people should take a longer-term approach regarding asset allocation, unless they’re on the cusp of retirement.
In 1986, Gary Brinson, Randolph Hood and Gilbert Beebower published a seminal study related to asset allocation. Based on a study of 91 large pension funds from 1974 to 1983, the study concluded that more than 90% of a portfolio’s return was primarily attributable to asset allocation vs. individual security selection. That was quite a revelation, since the focus for many years had been the selection of individual stocks or bonds rather than the overall allocation of the portfolio—especially for individual investors.
Investors typically take one of three primary approaches to asset allocation:
Strategic: The primary goal of a strategic asset allocation is to create an asset mix that seeks to provide the optimal balance between expected risk and return for a long-term investment horizon. Generally speaking, strategic asset allocation strategies are agnostic to economic environments, meaning they do not change their allocation postures relative to evolving market or economic conditions.
Dynamic: Dynamic asset allocation is similar to strategic asset allocation in that portfolios allocate to an asset mix that seeks to provide the optimal balance between expected risk and return for a long-term investment horizon. Like strategic allocation strategies, dynamic strategies largely retain exposure to their original asset classes; unlike strategic strategies, dynamic asset allocation portfolios adjust posture over time relative to changes in the economic environment.
Tactical: Tactical asset allocation is a strategy in which an investor takes a more active approach and tries to position a portfolio into those assets, sectors or individual stocks that show the most potential for perceived gains. While an original asset mix is formulated much like strategic and dynamic portfolios, tactical strategies are often traded more actively and are free to move entirely in and out of their core asset classes.
One hybrid approach which many 401(k) plan investors use is “rebalancing” the portfolio. This calls for using a preselected time frame, such as annually or semi-annually, to automatically review the current asset allocation to realign it to the target—say, 55% stocks, 40% bonds, 5% cash. When stocks increase relative to bonds, stocks are sold to get back to the target, and bonds are purchased—essentially selling high and buying low.
A variation of the rebalancing approach is to rebalance if the asset allocation is exceeded by a set percentage by establishing corridors. For example, if the target is 55% stocks, the rebalancing target might occur when stocks hit 65% and some sell, or when stocks are purchased when the portfolio composition drops from the 55% target to 45%.
Rebalancing can be an effective way to avoid an emotional approach, or trying to “time the market”—it applies more discipline to to managing risk and reducing portfolio volatility.
The bottom line when it comes to saving for retirement: The best long-term results come from a thoughtful, systematic approach that is based on a long-term horizon.
Dave Evans is a certified financial planner and an IA contributor.