A few weeks ago, the market was tumbling and sentiment dire. Partly to counter the gloom, I wrote a column suggesting that shellshocked readers, whose allocations might have gotten out of whack in the turmoil, take steps to ensure that their portfolios were properly situated for the stock rally that was sure to arrive at some point.
As it turned out, the current rally began the day that column appeared on Morningstar.com. I wish I could claim I'd planned it that way: the invitations to lavish parties at next year's Davos conference would already be pouring in. Unfortunately, in the column I made it clear that I had no idea when a rebound would occur. Oh well.
Anyway, whether or not the current upturn is the real thing, there's an important flip side to the advice in the previous column. Beyond figuring out what you want to be holding, and in what amounts, before a long-term revival comes around, you also should determine what you don't want to own.
Although that might sound unnecessary, deciding what you don't need is a critical task. For if the temptation during a bear market is to avoid thinking about your portfolio--or just go completely into cash--the temptation during a bull market is to chase the hottest sector in order not to miss out on the big prize.
The best way to dodge that temptation is to establish rules beforehand. If you wait until the boom is on, you'll find it extremely difficult to watch passively as the gains posted by some investment or another far surpass those of anything you own. Yet the super performers are inevitably narrowly focused investments that probably didn't merit a place in your investment plan prior to their ascendance and therefore won't deserve one afterward, either.
Building a Chinese wall
The hottest areas of the markets during rallies are typically the
riskiest. In that sense, the often-unreliable assumption that one must
take higher risks to get higher rewards does pan out. So it's likely
that country funds targeting a single high-growth market such as China
or Russia, or funds focused on specific sectors such as natural
resources or financials (hard to believe, I know) will lead the pack in
a future rally as they have in the past. Along with those, some other
sectors or fund types that are now obscure (or don't even yet exist)
probably will also take a place in the spotlight.
The winners won't just rise a bit more than broader-based funds and indices. They'll blow them away.
Don't wait until it happens to decide what to do. Decide now, and stick to your guns. If you have decided that your desired portfolio allocation does not include a specific China or natural-resources fund, don't buy one even when they're soaring and seem destined to soar ever higher. Then you won't be one of those unfortunate investors who jumps onto a trend when it's riding high only to lose out when it crashes not long afterward.
It can be done
One need not have superhuman powers to avoid the siren call of the
chart-toppers. Prominent fund managers make such decisions and stick to
them, even when maintaining their stance can cost them professionally.
At least one fund manager has been known to avoid all stocks in China
for a long time, saying they don't feel sufficiently comfortable with
the legal protection or shareholder culture to own companies there. So
even when the Chinese market caught fire in 2006-07, helping juice
returns of competitors, they didn't buy: the shareholder protection
hadn't improved, so there was no good reason to suddenly change their
tune.
Similarly, socially responsible funds set up a list of rules and stick to them. In their case, their shareholders would rebel (and probably leave) if the fund starting buying hot stocks on the prohibited list. But it's the same idea. If a socially responsible fund has declared oil companies to be off-limits, then it doesn't care if oil prices skyrocket and oil stocks are the best in the world. It won't own them.
You need not stay out completely
This isn't to say that no one should ever own a sector or country or
region fund. Just have a plan and maintain it. So if you're not going to
play sectors, countries, or regions (or individual stocks, for that
matter), decide now and stick to your vow. Conversely, if you like the
challenge, decide to put a small amount of money aside in a separate
account and do your betting there, vowing that under no circumstances
will you tamper with the other 90% or so that's devoted to long-term
allocations.
Approaching the issue in this manner will serve you better than simply waiting around and hoping you'll behave responsibly. Rather than vague hopes, you'll have a specific plan to rely on when the next hot play shoots to the moon, your friends are buying it, the media is shouting about it, and you can't for the life of you understand why you shouldn't sink all your money into it and become rich enough to fly your own private jet to the next conference at Davos.
