The dangers of the wealth effect

It feels grest to see the market appreciate and make us richer every day. It's also good for the economy, or so they say, because it makes people feel wealthier, and thus spend more. However, what's good for the economy is not always good for you.

That's because, in the long run, market returns are predictable. In general, it is widely known that, over a period of 100 years or so, the real return from equities has averaged about 7%. By real return, we mean net return after accounting for inflation. Hopefully, your long term financial plan and spending patterns are based on similar, or even more conservative assumptions.

There will be years when equities will gain more or less than 7%. There will also certainly be years when equities will lose. How you behave during those years will have a profound impact, not only on your investment performance, but also on your overall financial well being. And this is not only about avoiding panic or staying the course when markets tank. It's about maintaining a certain discipline and not losing sight of the bigger picture. If you spend more than planned or budgeted during a certain year, simply because the market did very well (say better than 7%) and made you feel richer than you really are, you will suffer in the following years, when markets gain less than 7% or even lose.

This is why it is extremely important to stay disciplined and not indulge too much in excessive spending in good years, simply because such good years are not sustainable. In fact, the so-called wealth effect, although good for the economy, can be dangerous for the less disciplined individuals. It creates the illusion that you are, or will be, richer than you thought, except that such illusion will fade away when the market humbles you again.

It is fine to tell investors not to panic when markets correct, but this is easier said than done, particularly when this was not expected, or not part of the plan. The proper attitude should be to manage your expectations and temper your enthusiasm when markets are doing well, and to remind yourself that good years are not sustainable and will be followed by bad years. Then, when markets correct, you can comfortably say that this was expected, and that short-term fluctuations are fine and anticipated as part of the plan.

Does that mean that, when the market tanks, you should sit and wait for it to recover? Not necessarily. A sound asset allocation strategy requires that you consider portfolio rebalancing. Unfortunately, however, many investors rebalance automatically, or blindly, without considering the long-term impact, or sometimes the long-term damage, that automatic rebalancing can do.

To demonstrate the effect of rebalancing in good and bad times, we have taken the S&P/TSX results from the year 1999 until now. We chose this period for two reasons: first, due to readily available data, and second because it is a good proxy of the long term performance history of equity as an asset class, given the compound return of 7% or so during that period. Third, and of equal importance, the chosen period encompasses two major market setbacks: the dot.com bubble burst of 2000 and the big market collapse of 2008-2009.

Now, this is what would have happened if you had followed a strict portfolio rebalancing strategy versus ignoring it. Between August 2000 and August 2002, Canadian equities lost about 45% of their value. If you had rebalanced on a regular basis, say annually, to maintain an equity allocation of 50%, you would have reduced your losses from 45% to 40%. Likewise, between May 2008 and March 2009, Canadian equities lost a similar 45%. Chances are, depending on the timing or frequency of your rebalancing, you could have reduced your losses by a few percentage points as well.

On the other hand, if you had just stayed the course and refrained from any rebalancing, you would have fared much better during that 19-year period. Your total return between 1999 and now would have averaged some 260% (roughly 7% annually compounded), versus about 150% only if you had regularly re-balanced. The bottom line is, although the popular strategy of portfolio rebalancing can reduce your losses during periods of market setbacks, it can significantly reduce your overall returns in the long-term.

As a matter of fact, despite its touted benefits, regular rebalancing is, in a way, counter-intuitive and defies the basic premises of investing, namely that equity is the best performing asset class and that investors should maintain a long-term perspective, and not get too much bothered by temporary losses. Now, we are not saying that rebalancing is always bad or that investors should totally ignore market fluctuations. However, we feel there are much better alternatives than automatic portfolio rebalancing. Consider the following key points:

First, given equity is the best performing asset class, one should start from the premise that one should try to maximize his or her equity allocation, noting that the market's long-term bias is upward. Having said that, the maximum equity allocation depends on each individual's specific situation, including the size of the portfolio, the investment horizon and the annual income and spending needs. This is a matter we have addressed in detail in our "Introduction to the Maximum Equity Allocation Approach". In a nutshell, the article proposes a framework for calculating how much of your portfolio you can afford to allocate to equities so that you can ride market fluctuations without panic, or without having to sell your investments at a loss when you get caught in the next bear market.

Second, the amount of money that you can afford to allocate to equities dictates what percentage of the total portfolio it represents. And that amount of maximum equity should be adjusted depending on your changing circumstances, again in terms of portfolio size, total income and spending needs. In other words, it's the maximum equity amount that dictates the equity percentage, not the other way round. So when you re-balance your portfolio, it is for the purpose of ensuring that you keep maximizing your equity allocation (without biting more than you can chew), rather than maintaining a certain hypothetical or arbitrary percentage.

In theory, portfolio rebalacing has some short term advantages in terms of dollar cost averaging or improving the chances of buying low and selling high. Problem is, as we have demonstrated with numbers, it does not work well in the long-term. The long-term market bias is upward, and thus if you engage in automatic rebalancing, you are bound to forego significant benefits.

That said, one should not totally ignore market trends, or market valuations, because there are situations where rebalancing could make sense. Historically, the market P/E ratio has averaged somewhere between 14 an d 16 times. The median range is somwhere between 12 and 16 times. There were periods when the market P/E dropped to 8 times, which are considered periods of severe market under-valuation. There were other periods where the market P/E exceeded 16 times (as it does now) which are considered periods of market over-valuation. Ignoring such periods of over-valuation or under-valuation would be foolish. Thus, in today's current market environment, it would make sense to cap your equity allocation at a certain percentage, or even reduce it (via rebalancing), in order to take advantage of market upticks and take some money off the table.

On the other hand, imagine a situation similar to that of March 2009, when markets had dropped some 45%. By then, the market's P/E ratio had collapsed to 10 times or so. At that point, or even earlier, it would have made perfect sense to rebalance and replenish your depleted equity percentage in order to take advantage of the market setback/under-valuation. However, by April of 2009, i.e. within a month or so, the market had recovered some 20% of its losses, taking the P/E ratio to 12 times or so. Should you have rebalanced again following such rally? Clearly not, because at a P/E of 12 times, the market was still significantly under-valued. Had you rebalanced at the first market uptick, you would have foregone significant gains.

How will you know when is the perfect time to rebalance? Unfortunately, the answer is: you won't. And we are not advocating that you engage in market timing or try to guess when is the perfect time to add or reduce your equity allocation. To the contrary, we are saying that investors should aim at maximizing their equity exposure (without biting more than what they can chew, again refer to our "Maximum Equity Approach" here), and should stay the course. We are also saying that portfolio rebalancing can be considered sometimes, but only during periods when the market has become clearly under-valued or clearly over-valued versus historical averages. What are those averages, when is a reasonable time to rebalance and by how much is something you should discuss with your investment advisor. You will not catch market tops and bottoms, but you will improve your overall portfolio risk and return in the long term, no more.

October 26, 2018