First of all, I am not a professional stock picker. I am an independent investor who never studied business and never knew what he was doing in the stock market – except saying to myself, “I’m not paying some broker to do this for me and charge me on the front end, the back end, and every in and out in between.

Back to my story.

I used to think there were two options for my IRA: mutual funds and individual stocks. Bonds were out of the question. One of my friends told me, “Just say no to bonds.” And I figured bonds were for people 65 and over who had “retired” from trying to make enough money to retire.

I tried mutual funds for several years, and from 1994 – 2000 I did well. Looking back, it was a no lose environment. You could throw darts at the charts and hit winners. Janus, T. Rowe Price, Mutual Series – it didn’t matter!

But along the way, addiction set in. Those 20 – 30% profits were not enough. I got caught up in the exuberance of technology. I craved the highflying funds that were amped up on tech stocks. Well, around 2001, things went south and I lost big time.

Along the way, I had ventured into individual stocks. I reasoned,  “Stocks can go up 5% in one day. That’s more than a lot of mutual funds accomplish in a year. This is a no brainer.” I paid for the price for that, too. Clearly I did not have the genetic makeup to do well in the stock market.

Eventually, I came out of denial. It was time for recovery. No, I didn’t go to Betty Ford. I went to the sidelines. I dried out. Went into cash and some of the most boring big companies I could find. I thought dividends were better than nothing, so I tried parking in places like Procter & Gamble, AT&T, Boeing – you know the names. That was a step in my recovery. Then I had a financial awakening.

Around 2007 I learned about ETFs. “Wait. These are just index funds with a fancy name. I don’t have any trouble falling asleep. No Ambien in my medicine cabinet. Why would I go the route of index funds and commit my IRA to years of sloth and boredom?”

Then I learned about asset allocation, spreading my money around to various asset classes and periodically rebalancing. I found out about the law of compound returns and that it works if you stop trying to beat the market — lower fees and fewer mistakes! Is this really how it’s done?

I learned more about the ups and downs of ETFs – how owning a basket of stocks made sense. After all, market movements make money for managers, not individual stocks. That was an awakening for me. And I learned how markets moved in opposite directions. So if US stocks were on the outs, other indexes would probably be moving up.

So I tried this new approach, cautiously at first.  Just a few ETFs. Although I had never fretted over my IRA at 3 am, I noticed that I was not so preoccupied with my IRA. “Mad Money” was less interesting than the Lakers’ game. The Wall Street Journal was still interesting, but I was not reading the financial pages first. I wasn’t checking my portfolio two or three times a day.

Okay. My name is Miller and I’m a stockaholic.

I still own a few large stocks. I admit it –– I am not fully recovered. I still have a stash of McDonalds, Apple and a couple of other anonymous stocks.

But on the bright side, I am 90% in ETFs. I have US stocks: small, medium and large. Bonds: short, intermediate and long. Europe (bad for the moment), Asia, Canada. TIPS (which performed remarkably well last year) emerging markets, REITS, global real estate, gold and energy. I am diversified big time, with allocations appropriate for my risk tolerance, age and when I will retire.

I feel very comfortable with this arrangement. I don’t worry about the market. When I do check my portfolio, the “reds” are offset by “greens.” When one market is having a bad day, invariably the bonds or other markets pick up the slack. I’ve given up stocks for ETFs and gotten back my sanity.

While traders fret and squabble over the next best stock to buy or sell, smart portfolio managers focus on the big picture, spreading money across broad asset classes including U.S. stocks, foreign developed stocks, emerging market stocks, real estate, bonds, inflation-protected securities and sometimes commodities. Asset allocation is supposed to reduce risk within a portfolio by spreading bets across investments that move independently of one another. While one part of your portfolio zigs, the other zags, helping you make money (and preserve capital) in all environments.

Recent critics of asset allocation, however, have pointed out that due to factors such as globalization, many assets including stocks now move in lock step. This trend, they say, is illustrated in the 2008 crash when all sorts of assets fell in tandem, supposedly revealing that the benefits of diversification are ephemeral.

A quick look at the core stock classes in 2008 shows that pain was evenly spread across every major category with U.S. stocks down 36.2 percent, foreign developed down 43.4 percent, emerging market stocks 52.9 percent, and even the nontraditional classes of REITS and commodities hit with declines of 37.6 percent and 31.9 percent respectively. Where is the non-correlation in this asset allocation? These facts, the critics point out, prove that the asset allocation models of the past are now bunk and in need of a desperate overhaul. 2008 is said to have sounded the death knell for all of modern finance. In response, one idea that has gained traction among some managers is the notion of adding global currency as a new type of uncorrelated asset class.

Is Asset Allocation Dead?

Did Modern Portfolio Theory (asset allocation) really die in 2008? MPT does not guarantee that an investor will make money every year. It really does not even say that asset classes will always be uncorrelated. What it does say is that on average, over time, asset classes perform differently, and a diversified portfolio will exhibit less variation in returns than a portfolio with one asset class. This diversification should lower risk, help investors stay the course and achieve their goals over the long haul. Did this hold true?

A look at some diversified portfolios shows that it did. In 2008, bonds returned 5.2 percent. Disciplined investors who kept a strong allocation to bonds experienced much less pain during this historic downturn. A 50/50 split between bond and equity allocation would have reduced losses by more than half. Less pain means a lower likelihood that an investor will panic and abandon their planned course during turbulent times. But woe to those who did bail out. In the following year, U.S. stocks were up 25.2 percent, foreign stocks rallied 31.8 percent and emerging markets gained a whopping 82.6 percent.

More diversified portfolios declined less than the markets over 2008 giving diversified investors the courage to stay with their plan. Those who stayed the course reaped a robust reward the following year.

For a dead idea, MPT worked pretty well.

Should You Add Currencies into Your Mix?

Some MPT advocates suggest that currencies as the new answer for a truly diversified portfolio.

Take currency returns over the past year. While Mexican peso was is down 7.8 percent against the U.S. dollar, the Japanese yen was up 7.5 percent and the Swiss franc up 6.7 percent for the same period. A quick study of currencies demonstrates that they are in fact highly uncorrelated to stocks. Should we then conclude that they belong in your retirement portfolio?

For the average investor, the answer is no for two simple reasons:

1. A diversified portfolio of stocks and bonds already provides exposure to global currencies. Large U.S. multi-national corporations may trade in U.S. dollars, but they conduct business in foreign lands using foreign currencies. By default they are already affected by currency exchange rates. Furthermore, beware of holding investments that trade in currencies other than the dollar as you are exposing yourself to both the risk of the underlying companies as well as the foreign currency. That presents a lot of risk to understand, let alone manage.
2. Currency values are tied more to inflation speculation than economic growth. History demonstrates that economic growth does not necessarily result in a stronger currency. If you think corporate profits are hard to predict, try predicting inflation. It’s a daunting task best left to the pros.

Placing all your eggs in one basket remains as bad an idea today as it did forty years ago when the fathers of MPT first began suggesting diversification strategies. Although 2008 was a rough spot for all investors, those who stayed true to diversification through the tumult are smiling today.

What many investors don’t know, however, is the Federal Reserve’s dirty little inflation secret. When the Fed reports on inflation, it reports on core inflation, a calculation that excludes food and energy costs.

The Fed has not always calculated inflation in this way. In February of 2000, the Federal Reserve rejected its old method of calculating inflation, which included food and energy, in favor of this new core inflation method, claiming that highly volatile food and energy prices made their influence impractical in determining monetary policy.

When you hear of the inflation rates of the late ’70s for instance, you are hearing about a number that included food and energy, whereas today’s number is skewed lower. Similar to how unemployment calculations have been skewed lower, using the 1970s method, both inflation and unemployment are higher today than most people realize.

The Fed has clearly revealed it wants inflation that is high enough to globally weaken the U.S. dollar, promote exports, and debase U.S. debt, but also low enough to keep investor confidence high and the economy moving forward. Fed chair Ben Bernanke has stated that the Fed is looking to stoke inflation to a rate of around 2 percent a year.

Unfortunately, inflation is not so easy to control. Inflation has a history of suddenly lurching out of control. Like a careening car that unexpectedly fishtails to one side, driver overcorrection will suddenly send the car dramatically sliding in the opposite direction and potentially out of control. Knowing this, the Fed wants to keep investors calm regarding the inflation story. Just last week, Bernanke suggested that inflation is not a threat and that the U.S. base interest rate will stay close to zero for an “extended period.”

What does this mean for you? Historically, developed economies have maintained an inflation rate of around 2 percent, while emerging economies have maintained a blended rate of around 6 percent. Strangely, these same economies tend to grow at similar rates as well.

People who live in emerging economies spend approximately 50 percent of their income on food and energy. In developed economies like the U.S., that drops to around 20 percent. Essentially, the poorer you are, the more your dollars must go to basic needs like food and energy. For the poor, their inflation tax goes up. Sadly, recent inflation of food, energy, and other basic commodities coupled with the deflation of the U.S. dollar is hitting many Americans harder than they may realize.

To respond to the inflation threat, every retirement portfolio needs to be inflation proofed. Start by allocating a part of your portfolio to Treasury Inflation-Protected Securities (TIPS). TIPS pay a stated dividend and also add the Consumer Price Index rate—a common measure of inflation—to the underlying value (PAR value) of the bond bi-annually.

Additionally, by adding exchange-traded funds like iShares S&P Global Energy (symbol IXC), iShares Dow Jones US Oil & Gas Ex Index (IEO), and iShares Dow Jones US Oil Equipment Index (IEZ) to your portfolio, you gain diversification to more than 300 companies impacted by the price of oil and gas.

Finally, add some precious metal exposure to your portfolio though ETFs like SPDR Gold Shares (GLD) or iShares Silver Trust (SLV), both of which will give you low-cost exposure to gold and silver. Beware of farming and food related ETFs because they involve futures contracts and are unpredictable.

But before you run out and turn your entire portfolio into an inflation hedge, remember that like inflation, deflation is also an ever-present risk. Just as quickly as the economy can careen toward inflation, a sudden overcorrection by the Fed can send the economy sliding wildly towards deflation.

Through global diversification and disciplined rebalancing, you can get the inflation pickpocket out of your wallet and rest assured that no matter which way the economy slides, you stand prepared to emerge a winner.

There is one conspiracy however, worthy of your attention: Those on Wall Street don’t want you to know that their industry is a sham. For Wall Street, the hypnotic malaise they cast over the unknowing investor is nothing less than an $11 trillion dollar shell game. Their gambit makes the baccarat table at the Bellagio look like the neighborhood lemonade stand.

And like any good shell game, they keep the pea moving so you never really understand what just happened. Hideous mutual funds vanish into thin air leaving only winners so that fund companies can claim their funds are leaping tall indexes in a single bound. High fees slip out the back-end of your account while you lie in bed asleep at night, thinking they got your back. And how about that reporting? It’s so convoluted you would have to be a Nobel Laureate in economics to even know what you made—or lost—after fees and taxes in any given year. Did you know that it practically took an act of Congress to force 401(k) providers to tell employees in plain language how much they are paying in fees?

Speaking of Nobel Laureates, fortunately there are a few that have been paying attention: Harry M. Markowitz, Merton H. Miller, William F. Sharpe, and Nobel candidate Eugene Fama, not to mention other notable luminaries such Princeton professor and author Burton Malkiel, John Bogle the founder of Vanguard, and William Bernstein, the acerbic author and truth teller. If you haven’t yet familiarized yourselves with their findings, the time has come to do so. They’ve blown Wall Street’s cover in reams of research. Never mind that they conclusively demonstrate that low-cost indexing beats active management by a long shot, or that the buy, hold, and rebalance style of investing trumps the vein-popping practices of Jim Cramer and crew.

Worse yet, the good guys’ PR campaign is weak. While they stutter in the corner, Wall Street is rolling out eloquent waves of hypnotic media, which roll over us as in a tsunami of minute-long TV ads, billboard artistry, and heart-grabbing radio spots. Each makes you want to pull out your hanky, pick up the phone, and call your mom to say you love her.

Who cares about facts when Smith Barney speaks? Why not talk to Chuck? He sure seems like a nice guy. His name is Chuck. Have you ever met a mean Chuck? Or what about the TD Ameritrade guy, Sam Waterston. He played stalwart Jack McCoy on the NBC series “Law & Order.” He sure cracked the code there, so he’ll be the guy I can trust for my retirement, right?

Yes, Charles Schwab, TD Ameritrade, and others are excellent brokers. For a fair, low price you can have excellent trade execution and fulfillment, as well as receive tremendous customer service and online reporting. But watch your pocket if you go to these firms for investment advice. Chances are they will roll out the four-color glossy print, full-court press, and slip you right into some mutual funds from their supermarket that drip, drip, drip away your hard earned savings in high fees and underperformance.

Conspiracy theories are for the birds. Ours, however, isn’t one of them.  Facts are for the discerning. When it comes to Wall Street, the facts have been revealed by the best economic minds in the world. Are you listening?

The investment business is like the movie business.  While you sit on your couch watching the dizzying array of security prices on CNBC there are many forces in the background. Every day, all day, thousands of experienced, highly educated investors from all over the world are working to find inefficiencies in the prices of everything from stocks in Egypt to municipal bonds in California. They are researching every security in the world from Dell Computers to Japanese debt to Euros to gold to pork bellies. They often know more about a company than the management teams running them.

They rarely take vacations. Armed with the most expensive computing power in the world, they are poring over data trying to figure out what a particular security is worth. They are setting up Google alerts to learn about an incremental piece of information from a remote blogger. They are hiring private investigators to check sell-through of products at retail. Some will stop at nothing to find the slightest edge. Recently, several hedge fund managers were arrested for insider trading because they paid moles inside of public companies to give them information that others didn’t have.

With this research, they form opinions and bet millions and billions of dollars on those opinions. They trade. They agree on a price. The buyer thinks there is upside, and the seller doesn’t believe there is enough upside—or he has lost so much he can’t take it. And that price changes in a nanosecond based on any new piece of incremental data—Steve Jobs’ health, a protest in Yemen, or even a bug found on an Intel chip.

You can think whatever you want about the price of bonds, gold, or U.S. stocks, but these investors have already thought about it, their computers have thought about it, and they’ve bid against one another to determine whether they are a buyer or a seller. All of that information is embedded in the price you see.

So what do the smartest investors do knowing all of this? They own a little of everything in proportions that make sense for their individual situation—knowing that in the next year, some of their holdings will rise and others will fall. Smart investors own stocks from the U.S., through a fund like Vanguard Total Stock Market ETF (symbol VTI), and around the world through funds like VGK and VPL. They own bonds through Vanguard Total Bond Market ETF (BND), and get commodities exposure through SPDR Gold Shares (GLD) or iShares S&P Global Energy (IXC), and real estate exposure in an ETF fund like RWR. They have the discipline to trim what is going up and buy what is going down. These investors bought more stocks when the S&P went below 700 in March of 2009 and trimmed their bond holdings. And today, they’re adding to their bonds and trimming their stocks.

It boils down to two choices as a retirement investor. You can have faith that capital markets will grow over time and generate a reasonable return without knowing where those returns will come from in a given year, or you can actively shift your money around, like a kid avoiding obstacles in a car racing video game.

In the end, the first choice yields tranquility and the second, heart palpitations. Don’t fight with a billion IQ points.  Own a little of everything because “nobody knows nothing.” ]]> http://www.marketriders.com/blog/2011/02/22/why-1-billion-iq-points-know-more-than-you/feed/ 0 http://www.marketriders.com/blog/2011/02/07/etf-basics-invest-globally-but-cautiously/ http://www.marketriders.com/blog/2011/02/07/etf-basics-invest-globally-but-cautiously/#comments Mon, 07 Feb 2011 16:24:50 +0000 Sally http://www.marketriders.com/blog/?p=753 Not all foreign stock investments are created equal. A few weeks ago, we wrote about owning stocks in companies based in emerging markets (Brazil, Russia, India, China) and the different types of risks and returns one can expect. The exciting growth in these countries also comes with a fair amount of risk, including governments with onerous tax rates, state-imposed price controls, outdated securities laws, corruption, or risk of wars and violence.

Egypt brings these risks home. If you want to invest in the Egyptian stock market, you can purchase shares of an exchange-traded fund (ETF) called the Market Vectors Egypt Index ETF (symbol EGPT), which holds all the important stocks in Egypt. When protests broke out last week, the markets decided that all of the largest companies in Egypt were worth 25 percent less than they were a day before, and EGPT fell by that amount!

Investing in foreign companies in the 27 developed countries (such as the UK, France, Germany, Japan, Australia, and Canada) gives you further diversification and is much less risky. In fact, over long periods of time, these economies perform like the U.S. stock market. Between 1970 and 2004, those stock markets appreciated 10 percent per year compared with the S&P 500 growth of 11 percent.

Every retirement investor should own these foreign stocks because they reduce risk in a portfolio in two key ways. First, you’ll own stocks in other currencies. If the U.S. dollar declines against the Yen or the Euro, these stocks will appreciate. Second, other countries have their unique responses to their own economic circumstances, their governments, their populations, and tax rates-all of which are different than the U.S. In the 1980s, the experts said Japan was going to take over the world and their stock market rose 28 percent versus the U.S., which returned 17 percent. In the 1990s, Japan’s markets tumbled and only recently have begun to recover. Demographics can also impact a country and the value of its companies. For example, other countries don’t have “baby-boomers” and their populations are aging in different ways.

Therefore, owning a basket of developed foreign stocks provides equity ownership that doesn’t always have the same fluctuations as U.S. stocks, which reduces risk in a portfolio.

In our MarketRiders retirement portfolios, we allocate about 30 to 35 percent of our equity exposure (not fixed-income), to non-U.S. stocks. Most of that allocation goes to developed countries instead of emerging-market countries.

Investors should own foreign developed country stocks through ETFs instead of mutual funds. The costs are low and active mutual fund managers statistically don’t do better than the indexes they attempt to beat. Also, foreign country mutual funds tend to have very high fees-it’s expensive to fly fund managers all over the world to research companies in foreign countries. Instead of paying high fees, just buy an ETF that holds all of the stocks in all of the countries that matter.

We recommend three ETFs in most of our portfolios. By owning shares in Vanguard European ETF (VGK), you own a basket of 481 large companies in 16 European countries and pay only 0.16 percent in annual fees, which is 10 percent of the cost of comparable mutual funds. Adding Vanguard Pacific ETF (VPL) gives you ownership of 493 large companies in Japan, Australia, Hong Kong, Singapore, and New Zealand. We allocate a small amount to iShares MSCI Canada Index (EWC), which charges 0.53 percent in annual fees.

Here’s the best part: With these three ETFs, you don’t have to worry about which country will grow faster, or whether Toyota will do better than BMW because you will own all of these stocks and capture the growth of these countries and their currencies. As for uprisings, you might sleep better with less risk of that occurring in these countries.

The consensus for fleeing bonds has become more powerful with each passing week. The first notable warning shot came from Warren Buffett at his annual Berkshire Hathaway meeting when he predicted the future demise of the bond market. Soon after, the Vanguard Group announced worries about bond instability. Journalists, economists, and wealth managers have joined in chorus proclaiming disaster in the bond market. With such a dire consensus, why would any investor still buy bonds?

One idea investors should understand is what we call the Third Newtonian Law of Economic Motion: For every economist, there is an equal and opposite economist. You don’t have to look far to find great minds lining up on the side of a long deflation wave fueled by a mind-boggling backlog of massive debt. Take Jan Hatzius, Goldman Sachs’ chief U.S. economist, who has been nothing short of shrill in warning of the severe deflationary risk still facing America and the world. Furthermore, according to a National Association for Business Economics (NABE) survey, 30 percent of their members still believe deflation is our primary risk for the next five years. Although no longer the majority view, deflation is still a concern for many.

Now consider John Mauldin, who publishes one of the nation’s leading financial newsletters. Last week he cited Gary Shilling’s predictions for 2011 in his annual investment strategies article entitled “9 Buys, 9 Sells.” Shilling’s first and most emphatic recommendation is, of all things, to buy bonds! Shilling passionately lays out eight arguments, from the hard landing of the Chinese economy to the U.S. suffering a Japan-like malaise, all in favor of bonds as an outperforming asset class for the next five years.

What then is the answer? Should one buy or sell bonds? The answer lies in one’s philosophy toward investing itself. If an investor is a long-term and principled retirement investor, he or she can escape the clamor of mass hysteria by sticking to a disciplined approach that rises above such frays. Will inflation or deflation rule the day? The principled investor humbly answers, “I don’t know.” Today it looks like we are leaning toward inflation. Tomorrow, news about a country or state defaulting, China’s inflation rate running rampant, or some other disruptive event may send deflationary fears toward the ceiling.  Yesterday’s news in Egypt sent investors back to bonds — go figure!

For the principled retirement investor, bonds are a critical asset class in a well-diversified portfolio. Much like a rock band that needs lead, rhythm and bass guitars backed by drums, so a retirement investor needs a bond allocation to make his portfolio sing. All the pieces of a retirement portfolio work together to make beautiful investment music. Each asset serves to help returns or mitigate risk in an atmosphere of intelligent skepticism about economic predictions. This approach dictates that it may be time to rebalance your portfolio by trimming equities that are flying high, and buying a few more bonds.

Owning real estate has its own set of risks and benefits. A property that is well-located and leased gives you debt-like cash flow with the opportunity for appreciation like stocks. Leased buildings are valued based upon the stability of cash flow from rents and the cost to replace the building. Real estate also protects you against inflation, as its value tends to move closely with the costs required to replace it-think land, bricks, concrete, steel, labor, and fixtures. These costs rise with inflation, and landlords raise rents over time if inflation grows.

Most investors, however, don’t want to buy a building. Fortunately, it’s easy to own real estate without ever fixing a toilet, or worrying about a roof caving in during a winter storm. You can get a well-diversified real estate portfolio by owning real estate in the form of real estate investment trusts (REITs). These are unique public securities because they pay no taxes and pass through 90 percent of their income to investors in dividends. From 1970-2009, public REITs returned an average of 9.1 percent per year. That means money invested in REITs doubled every eight years!

That doesn’t mean real estate won’t have ups and downs. REITs tend to trade in large swings between the fair value of the real estate held in the REIT to the stock price-from a 20 percent discount to a 20 percent premium. As you can see from the green box on this chart, between 2000 and 2009 REITs have been up or down by more than 35 percent. But while the stocks may swing, you can sleep at night knowing that you own hard, rent-paying assets.

The best way to own REITs is through an exchange traded fund (ETF) because the costs are low and you’d be hard-pressed to find an active fund manager with the expertise to consistently pick REITs over many years that will beat a REIT index. In fact, owning REITs through a mutual fund can cost you almost 50 percent of the yearly dividend you should receive, in manager fees. Therefore, instead of paying high fees, just buy an ETF that holds all of the REITs that matter. We recommend two SPDR Dow Jones ETFs in all of our portfolios to get REIT exposure: The SPDR Dow Jones REIT ETF (RWR) which indexes U.S. real estate and the SPDR Dow Jones International Real Estate ETF (RWX), which indexes international real estate.

For an annual fee of only 0.25 percent, RWR allows you to own the largest 81 REITs in the United States, including the largest American malls through Simon Malls, self-storage units at Public Storage Group, apartments, office buildings, and strip centers. Last year, investors received dividends of 3.61 percent.

For a fee of only 0.59 percent, RWX allows you to own a piece of companies like the Westfield Group in Australia with shopping centers worldwide and apartments and hotels held outside of the United States by Mitsui Fodusan. RWX paid a dividend of 3.46 percent last year.

Not all real estate assets serve the same purpose. Your personal residence should not be considered part of a proper real estate allocation because it is one highly concentrated holding largely for personal consumption. Owning raw land, real estate development projects, and hotels are not considered part of this asset class. These investments’ value relies upon the operating expertise of the principals, not the fundamentals of the real estate itself.

But owning REITs using an ETF gives you global exposure for a low cost and adds diversity to your portfolio. That’s why we  make sure you have them among your retirement assets.

Think of how radical this fact actually is. When you turn on CNBC or tune into Jim Cramer, you don’t hear cogent discussion on asset allocation. Rather, what you do hear is an expert waxing eloquent about his current prognostications on the market’s direction or which stock to buy or sell – market timing and stock selection advice. As the finance media spins like a whirling dervish over these matters, many investors wring their hands wondering if they should buy or sell, get in or get out. All the while real returns are being determined by the investor’s ability to identify and rebalance to asset allocations.

At MarketRiders, we sometimes describe asset allocation like the peloton in the Tour De France. The peloton is the large group of riders that move together in a pack. In the front, a strong rider “pulls”, a term for breaking the wind for the rest of the group. The lead rider must work up to 25% harder to help the peloton while the other riders enjoy drafting behind this lead rider. Once the lead rider becomes exhausted, he pulls back into the group, letting the next rider move forward to take a pull. Cyclists call this pacelining, and they know that by working together, they will, over the length of the race, achieve a significantly higher speed than riding alone. Even Lance Armstrong in his heyday could not come close to holding an individual pace that could match the speed produced through the shared work of the peloton.

Asset classes behave similarly.  For a season, one asset class will be out front, outperforming. But surely enough, in time, that asset class tires and drops back, in a sense, to regroup. Another asset class moves forward to pull your portfolio closer to your retirement goal. By keeping your target exposure to all your asset classes through disciplined rebalancing, you benefit like a cyclist in the peloton, always enjoying the work of a strong asset class that is leading your portfolio forward. To see how asset classes have performed over the past ten years, take a look at our education page.

Asset allocation worked just like pacelining over the past ten-year period of investing – a period billed “the Lost Decade”.  It was one of the worst in the past 100 years, with US equities losing a shocking 0.2% annually according to Wilshire Associates. As Rick Ferri pointed out in an interesting Forbes article, an investor who embraced a simple asset allocation strategy by diversifying across four classes (US stocks, foreign stocks, bonds, and REITS) and rebalanced to that allocation, realized a return of 4.2% compounded annually. Like a peloton, while US stocks got exhausted, the other classes pulled the group ahead.  Although this may not be the most exciting return, but for a lost decade, it isn’t too shabby. Asset allocation works.

And of course, a plethora of explanations quickly followed. We heard about the “fat thumb” scenario describing a trader who, keying in the wrong trade, sold billions of shares instead of millions, triggered the collapse. One of the more interesting explanations is a truly bizarre account involving Nassim Taleb, trader and author of “The Black Swan,” a book that discusses high-impact, impossible-to-predict, and rare events that are beyond the realm of normal expectations.  According to this grand irony, Taleb’s fund placed a sizable S&P short that got the ball rolling for Thursday’s violent selling — creating his own “black swan.”  In the end, however, the 1000-point drop remains a mystery, and in the absence of any truly credible and complete explanation, market fear has been resurrected.

More important than understanding the cause of this event is understanding how you responded to it.  Did you yawn, or did you freak? For those who live by the market’s vicissitudes, May 6th was an apoplectic ride on a terrifying roller coaster. With each swing of the market, such investors sit glued to the ticker, at one moment thrilled, the next gripped by dread. For those of us who are MarketRiders, such days produce a yawn.

With our investments sheltered by a distant time horizon, low fees and smart diversification, we are free to go about the more important business of our lives. Some investors prefer drama. We prefer peace-of-mind.