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If you’ve followed the analysis carefully so far, you’ll have noticed that there’s one gaping hole. Your asset allocation is a function of your financial needs and tolerance for risk. It results in a percentage allocation to bonds, domestic and foreign stocks, real estate investment trusts, and cash. However, I’ve consistently avoided giving any opinion about the relative attractiveness of these asset classes based on their current valuations. On the contrary: I’ve stressed that if you think that bonds, for example, are currently overvalued, then you should leave your allocation to bonds in cash until prices fall to a level you consider more reasonable.

The possibility that one or more asset classes are significantly overvalued is serious enough that it impacted the discussion of online brokers in Part 3. When you select an online broker you should think carefully about the interest you can earn on your cash, not just the cost per online trade. If you have a reasonable portion of your assets in cash, then the extra interest you can earn in a higher interest account should outweigh slightly higher trading fees for inactive traders, particularly given that you don’t need to execute many trades to rebalance an ETF portfolio and realize some tax losses each year. Most people want to leave a reasonable amount of their savings in cash as a safety cushion, but if you also have asset valuation concerns, then earning higher interest on your cash and being able to move it easily into a brokerage account to buy ETFs when the time is right becomes even more important.

But this leaves a critical question unanswered. If you think the time isn’t right now to put your cash to work in bonds, domestic stocks, foreign stocks, or real estate funds, how do you decide when it is the right time to move your cash into these ETFs? And on what basis are you judging that any of these assets are currently overvalued?

To make matters worse, a key attraction of the ETF portfolio approach is once you’re up and running you don’t need any valuation expertise. While other people are debating whether stocks and bonds are expensive or cheap, your decision to buy or sell is taken care of by your rebalancing rule. If bond prices rise a lot, your rebalancing rule will tell you to reduce your allocation to bonds. If stocks plummet, your rebalancing rule will tell you to boost your stock allocation. You avoid the emotional and intellectual challenges of deciding when to buy and when to sell based on a view of the market; and you have the added confidence of knowing that an effective rebalancing rule should result in consistently profitable (buy low, sell high) behavior. But how do you get going? How do you determine when to take the plunge and assemble an initial portfolio of stock, bond and real estate ETFs and closed-end emerging markets funds?

Before we answer this question, consider the worst-case scenario. You execute your asset allocation plan immediately in its entirety, and it turns out that one of the asset classes you purchased is significantly overvalued. Let’s stick with the overvalued bond example. (It’s topical, as many bond fund managers have recently commented that bonds seem to be fully valued or overvalued at current levels.) Well, here’s what will happen. As bond prices fall, you’ll lose money on your bond ETFs. Furthermore, your rebalancing rule will tell you to put more money into bond ETFs as falling bond prices decrease your bond holdings to below your target allocation. That may bring a double cost: if bond prices keep falling, you’ll lose some of the new money you’re putting into bonds, and if stock prices rise as bond prices fall, you may miss out by having sold some stocks to free up cash to add to your bond holdings. The more frequently you rebalance, the worse things will be. But eventually, when bonds hit fair value, you’ll have a (somewhat smaller) portfolio that reflects your target asset allocation. From there on, you’re fine.

How bad could this be? Bad. Imagine a 50% stock, 50% bond portfolio implemented at the peak of the 1999-2000 stock market bubble, and frequently rebalanced. It wouldn’t look too great now.

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Source: ETF Investing Guide: The Getting Started Problem