31. A Rebalancing Act

It's funny to read the analysts these days: they're bathing in the market panic, with useless advice such as "be active, stay with the winners, the coming days will tell us where the market is going", etc.

The demystified investor can sleep soundly, since she doesn't really care. Stocks going down only mean it will be cheaper to buy them. As long as you don't need the money now, and as long as you don't believe that the entire economy is going up in smoke, you should not be worried. And you should do nothing with your portfolio - unless it's your rebalancing day.

My rebalancing anniversary is December 25th. This is how it works. I set up a fixed ratio of my allocation goal (you can see it in my going naked post.) Let's assume, for simplicity, that your goal is 60% stocks and 40% bonds, invested in an S&P broad index fund and a well-diversified bond fund, respectively.

In a few months, when your rebalancing anniversary arrives, there are a few possible scenarios:

The market recovered to pre-crash numbers. You're still at 60-40. Nothing to do - hooray!

Stocks haven't recovered. Your balance changed from 60-40 to 40-60. You sell a third of your bond fund and buy stocks to return the balance to 60-40. The rebalancing forced you to sell high (bonds) and buy low (stocks). Hooray!

Or, stocks have recovered and passed their pre-crash levels, bringing your balance to 70-30. Everything looks rosy, the economy is looking great, but your rebalancing policy will force you to sell 1/7 of your stocks and buy bonds, returning to the 60-40 balance. Here, the rebalancing forced you to sell high and reduce your risk.

As long as the long-term prospects are positive, this method will ensure that you don't panic and sell after a crash, only to see the stocks bouncing back. It will also ensure that you're not tempted to over expose yourself to the stock market, thinking it can never go down. And, as a side benefit, it minimizes the number of transactions you do, commissions you pay, and of course taxes.

Of course, as I said in my last post, if you have a time machine or tomorrow's newspaper you can do much better. Unfortunately, I don't have them, and I'll have to stick with the second best option: the one listed above.

It's the third big market crash in 10 years. We recovered from the .com bust, the housing market bubble, the huge losses of the banks in 2008, the shock of 9/11, wars and other disasters. I don't see any reason to believe this time is different. The worst that can happen is a prolonged recovery or another mini-recession. So ignore the news, don't look at your numbers, don't try to predict the future, and, for god's sake, don't listen to Cramer or the other clowns. Enjoy the ride!

30. Don't Panic!

Contrary to the dire predictions, the debt ceiling crisis was averted.

Contrary to the optimistic predictions of a relief rally, the market tumbled the following day by 4-5%.

What should a demystified investor do?

First,

There are two excellent options, depending on the equipment you have.

If you happen to have a time machine, I would highly recommend going back to Wednesday (or, rather, two weeks ago), sell everything you have and buy gold.

In case you don't, a close second option is to turn off the TV, ignore the news, and stay the course. Remember, prices falling mean a better buying opportunity is coming. And your annual rebalancing day will use these attractive valuations to buy low (stocks) and sell high (bonds).

In any case, don't panic!

And, don't listen to all the experts who explain why this was expected, why it's happening now, and where we go. When times are good they'll predict unbounded prosperity. When the market falls, they predict doom and gloom. Neither version is correct, and the long term positive average is good enough. Stay the course and you'll be fine.

29. Doomsday

It could be funnier if it wasn't my own life savings: while many analysts say that it's likely that the debt ceiling will be raised at the last minute, and that even if it doesn't, the impact will be small and temporary, Credit Suisse says that stocks may fall 30% if the US defaults.

Is it time to panic?

I don't think so, and here's why:

• Market timing is a futile exercise. Stocks reflect the current expectations of all players - you can't assume you're smarter than everyone else and can predict the future better.
• Even if the debt ceiling is not increased, a default is unlikely. It's more likely that the effect will be something similar to a government shutdown (no money to pay teachers and soldiers) than a default (no money to pay interest and principal on debts.)
• Even if the stock market falls, will you know when to get back in?
• A last minute deal might push stocks up - when you're out. 

In short, like always, the best course of action is to stop reading the papers, stay the course, and check your portfolio again when it's time to rebalance. My rebalance anniversary is in 6 months. But I'd lie if I said that I can stop following the drama and the market. 

Personally, I gave in and sold 20% of my US holdings, but I had a good reason - a change in the way I calculate my holdings that was long due, and this week looked like a good time to implement it. 

For now, my advice is to take a deep breath, think long, and remember that this is all self-induced political drama, not any real economic development. See you all on the other side of Aug 2^nd.

28. Too hot to think?

As a heat wave is baking the North East, it appears that it's also melting some people's brains. For example, one of the chief clowns of the investment advice world is saying that you should stay away from technology in the summer. His reasoning? Companies have already spent their budgets in Q1 and Q2, and are not going to buy as much IT in Q3. This is true to some extent. Technology companies performance is cyclical: consumer electronics sells more towards the holidays, and the last few days of Q4 are always the busiest days for hi-tech companies such as the company I work for, EMC. But all that information is already well known, which means that it's already part of the price of the stock. There's absolutely no reason why the value of a stock shall rise or fall based on information that is already well known and is priced into the stock.

Suggesting to sell hi-tech at the beginning of summer and buying back when the weather cools down is one of the silliest ideas I've recently read. And I'm not the only one who thinks Cramer "Bear Stearns is totally fine!" is a total bozo. With this weather, I wouldn't be surprised if more silliness ensues. Drink a lot of water and stay cool!

27. Why Smart People Make Dumb Choices

In a survey done by the Vanguard Group, 85% of 401K participants consider themselves "unskilled investors" and would rather hire a professional to manage their account.

What about the 15% who consider themselves skilled and knowledgable? These tend to have the most education, have the highest incomes, and be higher up in the management chain. They also happen to have the lowest returns among the surveyed. How can that be?

One explanation is that smart people think they can - they should, in fact - get above average results. After all, this is what they're used to: above average intelligence, above average compensation, the corner office at work, etc. And so they try harder: they pick "winners", they sell "losers", they do their due diligence and research stocks and mutual funds, and believe that if they work hard enough they'll get above-average returns.

As we have seen, it's unlikely, or close to impossible, to consistently beat the index. The main result of all this activity is more fees, more days out of the market, more commissions paid to brokers, and, eventually, lower returns.

It's hard to let go of "being in control". It's hard to accept that average is the best we can hope for. Emotionally, intuitively, we all want to be above average, and we feel that the harder we try, the better outcome will have. We want to be in charge of our own destiny. And we believe that if we try hard enough, we will.

Take for instance your typical high-ranking executive in the corner office. Do you think they are modest enough to admit that they can't predict market movements? That they can't find the best analysts and investment tools? Of course not! They're too smart to lay their fate in the hands of the market. They'll buy, they'll sell, they'll switch course, they'll try to time the market, and, in general, a the losing game. As we saw in the past, Trade commissions alone and expensive management fees can eat a large portion of your investment over time. Add to that market timing errors, and you can see why those top brains end up with lower returns.

Unlike smart people, dumb people who follow simple dumb rules like those of Scott Adams achieve just average results - which is enough to beat the smart people. Sometimes it pays to be dumb!

26. Take care of the pounds, and the pennies will take care of themselves

An old English proverb says just the opposite: "Take care of the pennies, and the pounds will take care of themselves." In other words, a frugal life of saving a bit here and a bite there will lead you to financial freedom.

It's such a tempting thought! We'll buy the $3.99 a pound vine tomatoes instead of the $4.99 a pound fancy organic ones, or choose the $8 glass of wine over the pricy cocktail drink, or, as I did a few days ago, use the Amazon price-check app to find out that the $35 "How to cook everything" can be had for less than $20 at the Amazon bookstore. Hooray!

Funny how tempting it is to handle your finances in this way. After all, I've just saved 20-45% on the items mentioned above. Doesn't it add up at the end?

Well, yes and no. It does add up, but, perhaps, the time I'm going to spend on shopping online will be better spent on finding an index fund for my S&P 500 investments that has an annual fee of 0.07% instead of 0.08%. Sounds minuscule, but multiple it by the amount of savings and the number of investment years, and suddenly it's a little more important. But there are even bigger elephants out there in the room: what about your 401K investments? What about FSA (Flexible Spending Account for medical expenses)? If you have kids, have you looked into 529 plans? When was the last time you reviewed your student loan debts and checked if you can consolidate them with a lower rate? What about refinancing your mortgage?

Yup, it's not as much fun as bragging about saving 50% on those Nike you got online, but at the end of the day, we need to count dollars, not percentage points.

Like many other irrational behaviors, when it comes to money, our reptile brain leads us astray. We see the 80% discount we could save by driving to the outlet mall, and forget about the 2 hours it will take us to get there. If you were to buy a house today, would you drive two hours to save 0.02% off the price? But yet, a $100 saved on a shirt is as green as a $100 saved on a house. We think in portions and percentages, but, as far as your bank account is concerned, it's all the same.

Putting it another way, buying a $500,000 house is 5,000 times more important than buying a $100 shirt. If you plan to spend an hour shopping online for the best deal for the shirt, compare it to spending 5000 hours (or, 1.5 hours every day for 10 years) on shopping for a new house.

In reality, we all spend a little too much time on the "shirts", and too little time on the "houses". A better balance will save us all precious time and will also give us peace of mind. If you know that it doesn't really matter if that shirt cost was $50 or $150, since you more than made up for it when you bought that new car (or new house), you'll do you bank account a favor while freeing up your mind for more fun things.

So, take care of the pounds -- or the dollars -- and let those pesky pennies fend for themselves. They'll manage just fine.

25. Shedding Light on Your 401K

Have you checked your 401K lately? Is it alone, in the dark, begging for attention?

When I checked my 401K investments a few months ago, I found quite a few surprises. After a few years using the services of financial advisers, I decided to move to manage my finances on my own. Some of the investment they picked for me were fine, some were questionable. Many of them had high annual fees, which we know by now will doom you to low returns. On top of it, one of the funds had an outrageous load of 4.75% (meaning that for every dollar I put in the fund, I immediately lost 4.75%).

Luckily for me, the company I work for, EMC, has a pretty good selection of funds. I easily found index funds that suited my goals and complemented my overall investment strategy. You might not be as lucky, as this New York times article shows (thanks BG!).

Still, even with a poor choice of funds, and even with loads and fees, and even with employers who do not match employee's contributions, it's generally best to maximize your contributions to your 401K. The tax benefit alone is worth it. If you can also choose low-cost load-free index funds, you'd do even better. Just go and visit your 401K now, it's been sitting in the dark for too long!