I woke up this morning to see that the markets had fallen a bit again last night (as a guy in Singapore, my perspective of day and night might sound off to some of you, but it is what it is).

Unfortunately, 78% of our “Stock” dollars rose last night instead.  Our overall account gained another 1.5% yesterday, while the market dropped nearly half a percent.  Naturally, we don’t want market prices to rise—we’d rather get good deals instead.  Since July 1, 2009, the S&P 500 index has increased 13.5%.  But since the same time period, our account has gained 26.4%.  I’m not happy about that.  Our new investors might be surprised to hear this, but if we’re going to be net purchasers, we want cheaper prices, not higher prices.

If you don’t mind me standing on the soap box, I could give a bit of written advice to anyone handling their own personal account money, outside the club.  At least, given where I am, nobody can hit me with an egg from where they’re sitting.  So here goes:

Clever portfolio asset allocation, with your own private funds, is likely going to have a bigger impact on your investment performance than what you choose to buy does.  People are often pretty surprised to hear that, but it’s true. 

Yale’s University Endowment Fund manager has beaten the market handily over the past couple of decades, despite having a large bond component.  In fact, it’s easy to argue that—even before the 2008 market crash—he had beaten the market because of his large bond component.

One of my clients recently asked me about the correlation between the stocks in her account, and the bonds in her account.  She asked, “Do bonds go up when stocks go down, and do bonds go down when stocks go up?”  The answer is yes, most of the time, that’s what happens.

Here’s the emailed explanation I gave her yesterday:

The stock and bond markets do operate somewhat inversely to each other.  It’s all based on supply and demand.  When people want something, they buy it, driving the price up.  People don’t tend to be emotionally intelligent.  They like to buy things that are going up in value.

Think of it this way:  if the markets have made 10% per year, as an average, for the past 100 years, and then suddenly, they start making 15% per year, most people start getting ecstatic about that and they buy more.  But if the 100 year average is 10%, then the market (if it makes 15% year over year) is going to get ahead of itself.  And at some point, it has to take a breather and/or a drop, because it can’t sustain that kind of growth.  (FYI—the markets made 17.5% as an annual average from 1982 to 2001)  Most people are emotionally foolish.  When the markets are rising more and more, they say “to hell with safety and bonds”, and they buy the rising stock products.  Where do they get that money?  Often it comes from bonds, CDs, mattresses etc.  And then what happens to bond prices, because people are selling bonds to buy stocks?  Bond prices then fall.

That’s the time to be buying bonds, rather than stocks.  When stocks fell, earlier this year, you made a small killing on your bonds.  Why?  Because everyone else was scared of the stock market, and they wanted to buy some of your bonds.  This drove the prices of bonds up.  But you already owned them, so you benefitted from their fear.  Likewise, when the stock markets got hammered, you shunned buying bonds and you bought the stocks that everyone else was selling.

Bonds are generally pretty sleepy—they don’t move a lot.  But your own bonds  have made more than 7% this year, even though they only had an interest payout of 3%.  The price of them rose as more and more people ventured into them from the stock market.  At one point, your bonds were up something like 8%+.  But the stock markets started rising, so people joined in and lightened up on bonds a bit.

We are sticking to a simple, non emotional plan.  Your bond allocation will equal your age, more or less.  When stocks rise, you’ll need more bonds.  When stocks fall, you’ll need more stocks—in order to keep the balance exactly where we want it.  According to research by David Swenson, Yale University’s endowment fund manager, (he’s an amazing investor) no matter how smart an investor is, his/her likelihood to rebalance is nearly 0.  People have a tough time buying something out of favour and shunning something in favour.   If you can remove your emotions and follow textbook allocation principles (time tested since the dawn of time) then you won’t be a victim, long term, of the markets.  Instead, you’ll be like that Buddha that works in partnership with it.  I hope that answers your question.

To walk the walk, I found myself looking at my account recently, with some money to invest.  Stocks aren’t unreasonably priced, but my bond allocation had dropped to about 36% of my total portfolio.  So to rebalance, all I had to do was buy some bonds. 

I bought 407 shares of the Canadian short term bond index (ETF) earlier this week.  The ticker symbol is XSB-To.  And I’ll keep buying bonds until they represent 40% of my account again.  If my stock market holdings keep rising, of course, I’ll have to keep buying bonds.  But here’s the beauty.  When the market crashes, I can sell many of these bonds (because again, I’ll need to rebalance) and I can concentrate on buying stocks with the proceeds, and keep buying stocks with my monthly investable money until I get back to the allocation I need.

If you want to see how an annually rebalanced portfolio of stocks and bonds has beaten a straight portfolio of stocks over the past 33 years, have a look at this one.  The tracking, I believe, is the brainchild of Ian McGugan, the founding editor of MoneySense: CCPP – Historical Performance

A blend of 33.3% bonds and 66% stocks has beaten a portfolio of 100% stocks by 28% since 1976.

It won’t do it every year, but overall, rebalancing stocks and bonds will add safety and, studies show, increase your overall raw performance.

But having a balanced account is tough.  Because the biggest enemy to our financial success is the person we face in the mirror each day.  People get swept up trying to jump on the fastest horse.  But doing so might ensure a trampling, rather than a market-beating performance.