|
My wife has learned never to send me to Sam’s Club or other discount warehouse stores unattended. Despite giving me the most detailed shopping list imaginable, I inevitably leave the store with an entire case of mayonnaise or a 50 pound box of bacon. When questioned by my wife why our family would possibly need so much mayonnaise or bacon, my response always sounds something like this – “It was such a good deal it was just too good to pass up! And let me show you how much I saved on ten cases of chocolate syrup…”
Whether you are buying a new car or more mayonnaise and bacon than you will ever eat in a lifetime, getting a good value is inherently satisfying to almost everyone. This is especially true in the investing process, where purchasing large amounts of value priced investments is not only satisfying; it is one of the basic principals of a successful investment strategy.
Buy Low – Sell High
Everyone is familiar with the most fundamental rule of investing: “buy low – sell high.” The “buy low” part of that rule implies that you are purchasing an investment for a price which is lower than it is inherently worth - in other words you are buying an investment which is a “good value.” Not surprisingly, the same rule for success when shopping in a discount warehouse store is also true when shopping for investments - if you find something which is a good value, buy a large amount of it!
This strategy of buying value priced investments “in bulk” forms the basis for a fundamental strategy in investing – tactical asset allocation.
Tactical Asset Allocation
What is tactical asset allocation? It is the process of overweighting positions in your portfolio to take advantage of favorable investment valuations. For one reason or another, good investments will sometimes become undervalued. This undervaluation may be the result of economic forces, lack of investor confidence, or any number of other factors. However, as the circumstances which originally caused the investment to become undervalued disappear, the investment’s price will typically rise to reflect a more accurate or fair valuation level.
If you had recognized the favorable valuation and purchased the investment at the lower price level, you will of course benefit from the rise in price to the more accurate valuation level. And if you had tactically over-weighted your portfolio’s allocation to the undervalued investment, your returns would be magnified. Sounds good, but does it work? Let’s take a look at an example to illustrate the power of a tactical asset allocation approach.
Small is Mighty
In January of 2000, small company U.S. stocks were not on the radar screen for most investors. Large company names like Microsoft, Intel and General Electric dominated the headlines, while small company names like La-Z-Boy and Tupperware were out of favor with most investors. As a result of this situation small company domestic stocks were valued at deep discounts to their large company counterparts. Assuming you had recognized the undervaluation of small company stocks in January of 2000 and bought these stocks “in bulk”, your portfolio returns would have benefited greatly from the subsequent price appreciation in this asset class.
Last month’s column illustrated how a portfolio which consisted of 80% large company stocks and 20% small company stocks produced over 10% of additional return versus a portfolio invested 100% in large company stocks for the period of January of 2000 to December of 2005. Knowing, however, the attractive valuation of small company stocks in January of 2000, let’s assume that the decision was made to tactically over weight the diversified portfolio to 40% small company stocks and 60% large company stocks. For the period of January 2000 to December 2005, this tactical portfolio would have achieved a total return of 13.63%, or approximately 22% higher than the portfolio invested only in large company stocks. Tactical allocation not only works, it can make a powerful difference in portfolio returns.
Timing is Everything
I would love to tell you that tactical investing is an exact science and the decisions on when to purchase and sell undervalued securities is completely straightforward. However, this is obviously not the case. In employing this strategy, our firm may study a valuation trend for a significant period of time before making a decision to purchase an undervalued asset class. A tactical asset allocation strategy does require additional effort beyond a buy and hold strategy, so in implementing this strategy you may need the help of a professional. However, as the above illustration indicates, a tactical asset allocation strategy can significantly enhance investment returns, and be much healthier for you than twenty cases of mayonnaise or fifty pounds of bacon.
Source: Morningstar
|
