Handling Your Emotions: Using Asset Allocation And Beta

by: Michael Connellan

Volatility, uncertainty and anxiety all make investing in securities an emotionally challenging effort, and learning to deal with those emotions is perhaps the most difficult single aspect of investing. Modern communications, 24/7 Bloomberg, CNBC, and Fox are constantly interesting, but also constantly prodding us - to quote a line from a great Eagles song - to "I can hear a voice inside me say, do something!" Yet when you step back and look at a long term chart over many decades, what seemed like the biblical Armageddon at the time becomes just a minor blip in the chart. The current Euro zone issues are just the most recent example. But we're all human, and research shows we're twice as sensitive to losses as we are to gains.

Each year in January I carefully review every trade I made during the entire prior year, and I look at what each security did after the fact, and what would have happened had I done nothing. This was especially enlightening in Jan 2010 when I studied the 2009 trades, particularly those in the Feb-Apr period when the global markets were at their nadir. It was a humbling experience! But it reinforced two lessons in my mind in dealing with emotions and investing: first, to reduce the frequency of trading; and second, that very often doing nothing would have had a better outcome! So when there's turmoil around you and it seems like you should 'do something', take a moment to consider simply pausing and not doing anything. If you did your research carefully before you invested, and the company in which you invested is still doing well, then the stock going down isn't reflecting any poor performance by the company but rather market fears. Research has shown that in the short run, as much as 60% of the movement in a stock's price is driven by the overall market and not by the underlying company.

In what Warren Buffet calls "By far the best book on investing ever written" - The Intelligent Investor by Benjamin Graham - the issue of asset allocation is discussed at length. That is to say, basically, what proportion of the portfolio should be in stocks, and what proportion in bonds. Prof. Jeremy Siegel in his excellent book Stocks for the Long Run makes a well-researched case for stocks being best, but Ben Graham takes a more tempered view. In Graham's words, the investor should " ... divide his holdings between high-grade bonds and leading common stocks ... (and) the proportion held in bonds be never less than 25% or more than 75%, with the converse being necessarily true for the common stock component; (and) that the simplest choice would be to maintain a 50-50 proportion between the two."

In my own portfolios I follow his guidance, and typically maintain approximately a 50-50% ratio but with stocks being at times as much as 60% if I think the market is undervalued. In addition, though, I use beta to measure volatility as well. By sticking with very high quality, dividend paying stocks the overall beta in my portfolios averages about 0.65 relative to the overall market which is 1.00. While volatility and standard deviation aren't the same as risk, emotionally, less volatility leads to more peace of mind. In addition, in my bond portfolio I use primarily individual bonds rated at least "A" and mainly "AA", and I hold those all to maturity. So at the end of the day I'm unconcerned about fluctuations in bond prices since I know that at maturity they'll be redeemed for 100 cents on the dollar. Combined with a low beta strategy, this means that on any given day my portfolios fluctuate only about 40% as much as the overall stock market. This means that if the market declines 2% - roughly 240 points - my portfolios overall decline only about 40% of 2%, or 0.8%. Painful, but not devastating.

In summary, by following Graham's advice and using approximately a 50-50 balance of high quality bonds coupled with superior dividend-paying stocks, and considering beta when buying stocks, it becomes easier for a long term investor to ride out the extremes of market volatility and emotions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.