Rush Hour, Market Volatility, and Evidence-Based Investing: Part I
Have you ever been caught in rush hour traffic? Do you find yourself feverishly searching your GPS for a faster route the longer you are stuck in it? Maybe you contemplate whether you’re better off waiting out the bumper-to-bumper gridlock on the highway or taking your chances with city traffic lights. You know that your chances of outrunning highway traffic with an alternate route are slim, but your impatience is chipping away at your sense and you strongly consider it. Plus, look at all those other cars clearly getting off to avoid the slowdown!
But what does rush hour traffic have to do with investment philosophies?
Rush hour traffic is like market volatility and your traffic decisions are your investment philosophy. You either believe it’s more advantageous to get on the highway and stay the route despite possible slow-downs, or you believe in exiting the highway when things back up and entering again when the coast looks clear.
The former ideology is similar to Evidence-Based Investing (EBI), an investment philosophy that is based on long-term buy and hold strategy. Evidence-based investors use asset allocation and diversification to construct their portfolios in such a way that they reap the greatest rewards by getting on the metaphorical highway and waiting out any slow-downs that may occur, trusting that things will inevitably pick up. As such, EBI proponents invest in low-cost, passively managed index funds that operate according to these same ideals.
Asset Allocation and Diversification
Asset allocation is the process of dividing up your investable assets among different asset classes, which include (1) domestic, (2) developed international, and (3) emerging market versions of:
• Stocks/ Equity: ownership in a business
• Bonds/ Fixed Income: a loan to a business or government
• Hard Assets: equity in tangible assets such as real estate
• Cash or cash equivalents
Asset classes can be further subdivided by dimensions of expected sources of return. For example, stocks can be classified by company size (small-, mid-, or large-cap) or business metrics (value or growth). Bonds can be classified by type (government, municipal, corporate), credit quality (high or low), and term (short, intermediate, long).
Which assets you hold, and in what proportion, will vary by investor and will be largely based on both your timeline, tolerance for risk, and your need to take risk to meet your financial goals.
Your timeline is the expected number of years you’ll be investing to reach your financial goal and your risk tolerance level is your ability or willingness to lose part or all of your original investment for a higher rate of return. For example, someone with a longer timeline may feel comfortable investing in riskier asset classes early on, but choose fewer risky investments as they near closer to their goal date (retirement, for example).
All investments bear some level of risk, but without question, some are riskier than others. Investing in multiple asset classes can help to reduce overall risk while still positioning yourself for long-term returns.
The goal is to pinpoint which allocations seem to best serve the needs of the portfolio at hand. Different ends require different means.