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Don't commit this investment "crime"

(MoneyWatch) It's been a very good year so far for stocks around the globe, with the exception of emerging markets. Even though we haven't completed eight months, U.S. stocks have provided returns well above their historical annual averages, with small value stocks leading the way. Strong recent returns often lead to bad behavior by investors. They either commit the "felony" of becoming overly aggressive -- increasing their allocation to stocks -- or commit the "misdemeanor" of becoming complacent, failing to rebalance their portfolios.

Rebalancing requires you to buy when your allocation falls below the minimum allowed level and to sell when it exceeds its maximum. This year it might mean having to sell stocks to buy bonds, and within the stock allocation to sell U.S. small value stocks to buy emerging market stocks. Unfortunately, most investors find it very difficult to sell what has done well to buy what has done poorly. It's one reason why the winning strategy is simple, but not easy.

Bear or bull -- both are wild

The tendency for investors to do the opposite of what they should be doing is why I often write about the opposite of what's going on in the markets. During bear markets I'm reminding investors that the light at the end of the tunnel isn't a truck coming the other way. Governments and central banks are likely to take actions to address the issues that led to the bear market. I'm also reminding them that their investment plan should have anticipated that there would be bear markets that would be unpredictable in their timing and nature. The best course is to stay disciplined, buying stocks to rebalance while others are engaged in panicked selling.

Likewise, during bull markets, I'm reminding them that bull markets do end in unpredictable ways and that's it's just as important to remain disciplined and rebalance.

The great unknowns

With that thought in mind, I thought it would be helpful to provide some reminders about the investment risks that are out there. The following is a very brief list of some of what we can call the "known unknowns." It's important to keep in mind that it's often these developments, such as the September 11 attacks or the 2011 Japanese earthquake, that cause bear markets.

  • Congress must settle on new plans to fund the U.S. government by the end of September. Their failure to reach an agreement could disrupt both the stock and bond markets.
  • The Treasury is expected to hit its debt ceiling sometime during October or November, raising the specter of a default and even another downgrade in the country's credit rating.
  • The Middle East has become more unstable, especially with Egypt falling into turmoil. Problems there could lead to a disruption of oil supplies and sharply rising prices.
  • The Chinese economy is slowing at a faster pace than almost anyone expected. Given the size of China's economy, a slowing there has effects around the globe, particularly in the emerging markets.
  • In general, Europe's economies have still not emerged from recession, and there's always the threat that the debt crisis in countries like Greece could once again dominate the headlines.

I'll note that the sequester and tax increases have led to the budget deficit shrinking much faster than almost anyone expected. In addition, the resurgence of the domestic energy industry, led by the revolution in natural gas production, has led to a dramatic drop in our trade deficit and helped stir a revival in domestic manufacturing (in industries that benefit from low natural gas prices). A reduction in the trade deficit shows up in more rapid growth of the GNP.

Maintain control and stick to your plan

Smart investors know that they cannot predict the future, which means they don't control the returns from their portfolio. Thus, they don't focus on trying to manage returns. Instead, they focus on managing the things they can control -- the amount of risk they take, diversifying those risks as much as possible, keeping costs low and tax efficiency high. Failure to rebalance means that you've turned over control of the risks in your portfolio to "Mr. Market." While rebalancing may go against your natural instincts, it's an important part of the winning strategy.

If you have a written investment policy statement and rebalancing table, make sure you check it on a regular basis (I suggest quarterly) to see if there's a need to sell some winners and buy some losers. If you don't have that written plan, it's time to write one -- it's impossible to stick to a plan if you don't have one in the first place. So write a good plan and avoid committing investment crimes (being overly aggressive or not rebalancing when necessary). A bad record could haunt you forever.

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