Dr. Richard Marston is the director of the Weiss Center for International Financial Research and director of the Institute of Private Investors Program at the Wharton School of the University of Pennsylvania, where he is also a member of the faculty.
Marston outlined his thoughts in a recent report, "Managing Booms & Busts in Today's Portfolios."
I have provided some of his thoughts:
Many investors have seen a solid three years of economic rebound with some markets soaring beyond the most optimistic expectations. It's times like these that wise investors re-evaluate their portfolios by addressing the following questions.
• What are the potential effects of a booming market on a portfolio?
• How can investors control risks in their portfolios?
• What examples of booms and busts from the past can we look to for guidance?
For three straight years, the strong economy has proven its results month after month, quarter after quarter. The economy has had a solid growth ever since the second quarter of 2003. For 2006, we will most likely see growth between 3 and 4 percent according to Wall Street Journal consensus forecasts. We've had significant growth in employment and collectively these are the ingredients of a solid recovery.
On the other hand, some investors are worried about higher interest rates; however, in my opinion, the interest rate environment doesn't seem to be a major risk to economic expansion for a couple of reasons.
We've transitioned to higher interest rates without any major casualties. The Fed lowered rates all the way down to 1 percent and reversed the process starting in June 2004. Now, the end of the rate hikes seems likely.
In the meantime, the economy continues to surge on and on. Some specific sectors - in particular the home-building industry - may experience a slowdown, and some mortgage holders may find themselves overextended, but overall the economy as a whole has adjusted very well to these higher interest rates.
There are some risks, of course, as there are always risks in an economy in any kind of expansion. Marston believes the most important risk right now is the oil market. The problem, however, is not coming from record oil prices, but rather that we no longer have the kind of spare capacity that we had in the 1980s and even during the Gulf War of 1990.
The oil market is so tight that he believes we are vulnerable to a major shock. It would only take one of the major producers, i.e. Iran or Nigeria, cutting off supply to give a major jolt to economic expansion.
Investors who have taken a much more aggressive stance during the past three years have been fortunate, particularly if they got back into the equity market and adopted a long-term portfolio stance.
But now that investors have made some money in particular markets, it's time to use common sense.
It's during times like these that investors should reassess their risk positions and conduct some prudent rebalancing strategies. To control risk in the portfolio it is important to harvest the gains by rebalancing.
While the economic expansion may have had a positive impact to investors' portfolios, they should be paying attention to their returns and its effect on portfolio asset allocation. Investment advisors recommend long-run portfolio strategies designed to maximize long-term returns for a given level or risk. However, as some assets outperform others in the portfolio, the strategic allocation can "drift." Investors can counteract that "drift" effect through periodic portfolio rebalancing.
The rebalancing process is counterintuitive since you're essentially selling winners and buying losers. Marston advises that investors look at this process differently. Consider rebalancing as a buy low and sell high strategy. Today, bonds are much more attractive than they were three years ago and emerging markets are much less attractive than they were three years ago.
No one can time cycles of boom and busts in the financial markets. But a prudent investor knows enough to rebalance when an asset class has done particularly well. You've got to have the courage to cut back to your normal allocation even after large gains. Recognize that because of the large gains, the stocks will have changes in valuation. The expectation of higher gains in the future is going to be less than it has been in the past.
Caution is in order - not because there's anything negative about the American economy or the overall prospects of investing. Rather, it's important to be cautious and cut back on some of these gains to make sure investors increase the likelihood that they can continue to grow these portfolios over the long run.
For a full copy of Marston's report, e-mail me William.a.Creekbaum@smithbarney.com or call 689-8704.
• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.