The Globe and Mail, Report on Business
Published August 18, 2007

By Tom Bradley

Shouldn't I be doing something?

In historical terms, volatile markets like we're experiencing now are not unusual, so I don't want to overplay it. I'll admit, however, that I have been watching the screen more than I usually do.

It has been enough of a roller-coaster ride that I think it's useful to look at what portfolio managers are doing and what individual investors should be doing through this period.

Professional money managers are spending a lot of time doing what we're all doing. They're trying to figure out whether this is the end of the good times or just a little blip on the long-term chart. Even bottom-up managers who don't try to time the market can't help but wonder if the stocks they are looking to buy are going to get even cheaper.

If managers use formal risk models, you can bet they're updating them daily to make sure the fund is positioned where it should be. Depending on the type of fund, this may refer to asset mix, bond duration or the economic factors likely to affect the equity holdings. More active traders or leveraged hedge funds will be looking at their quantitative models in real time. And they will be looking for liquidity wherever they can find it so they can continue to trade.

Assuming the fund managers are not making radical changes (i.e. switching from aggressive to cautious or vice versa), they are likely freshening up their research on the stocks they want to buy on weakness. A stock that wasn't a compelling value two weeks ago may now be in their buy range.

In markets like we're experiencing, Mr. Market isn't very discriminating and often the baby gets thrown out with the bath water. The increased amount of indexed assets exacerbates this phenomenon because redemptions necessitate that stocks are sold across the whole fund. If active managers are willing to act, however, they can tap into excellent value situations.

Individual investors should also be doing some of these things, although their work won't likely lead to much action if their portfolio has been structured correctly.

The one thing they shouldn't be doing is trying to time the market. It's been shown that the professionals have limited success doing it, so it's hard to expect that someone at home can do any better. The individual investor may be very confident, but their bold view is likely laced with emotion and influenced by the current state of affairs. That's a bad combination and generally leads to poor decisions.

Peter Bernstein, a veteran analyst and economist from New York, says market tops and bottoms are defined by a “switch from doubt to certainty.” He goes further to say that “in calmer moments, investors recognize their inability to know what the future holds. In moments of extreme panic or enthusiasm, however, they become remarkably bold in their predictions.”

False confidence is not the only challenge for individual investors. The other big one is the overwhelming feeling that they should be doing something. For investors who have let their portfolio get out of line from where it should be — a larger-than-normal equity weighting, little or no foreign diversification or a huge bet on one sector — changes are in order. They should move swiftly to get their portfolio closer to its target asset mix.

On the other hand, investors who have stuck to their strategic asset mix will have nothing to do. At some point they will need to rebalance their portfolio, but that can wait until after the fireworks are over. In the meantime, it's best they enjoy the rest of the summer in the backyard, on the golf course or at the cottage.

With regard to asset mix, I've always been in the camp that it is impossible to generate consistent returns by market timing. This applies for everyone, whether they're sitting at home or in an office tower. Clearly, that view has influenced my approach to asset allocation.

In a nutshell, an investor should assess their objectives and risk tolerance and then commit to a strategic asset mix (read: long term). For the disinterested and/or unknowledgeable investor, that mix should be set numbers (i.e. 30 per cent Canadian equities, 30 per cent foreign equities and 40 per cent bonds).

For more engaged, experienced investors or professionals, the mix can provide a little more latitude (i.e. 25-35 per cent Canadian equities and so on). This gives these investors the ability to express a view, but prevents them from blowing themselves up if they're wrong. In both cases, I suggest rebalancing once a year or as contributions and withdrawals are made.

In my last column, I referred to the fact that I started tilting towards caution a year and a half ago. While I was too early and was out of sync with the sizzling market, my asset mix ranges kept me in the game and allowed me to generate attractive returns.

Market peaks and troughs are not a time to make big changes to your portfolio. Investors who feel they have to act at times like these often make poor decisions and seriously affect their long-term returns. If you want to watch the show, go for it. Just don't try to be a participant.