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Don’t Let Asset Allocation Drift into a Naked Dream
October 14, 2021

Don’t Let Asset Allocation Drift into a Naked Dream

It was a normal day at my elementary school. I sat at my desk, tossing rolled up pieces of paper at the back of my friend’s head. Then the bell rang for recess. I got up and entered the packed hallway to grab a snack from my locker. That was when I froze in horror.

I realized I was wearing nothing but underwear.

Over the years, I’ve had variations of this dream.  I’m in a public place, everything is peachy, and then I figure out I’m naked or wearing nothing but skivvies.  Something similar happens to investors.  I call it “Asset Allocation Drift.”  It happens slowly, and investors aren’t aware until they’re standing in their birthday suits.  Other investors never figure it out, even though it costs them a lot of money.

To understand what this means and how it happens, let’s poke fun at your northern neighbors.  Plenty of Canadians had globally diversified portfolios of index funds or actively managed funds back in 1999.  They owned a portion in Canadian stocks, U.S. stocks, international stocks and bonds.  But over time, they increasingly shifted to Canadian shares. And why wouldn’t they?  Canadian stocks crushed U.S. stocks. 

Measured in Canadian dollars, the S&P 500 gained 13.9 percent in 1999.  The Canadian stock index trounced that return, gaining 31.7 percent that year.  Several Canadians said, “Our stock market did really well last year, eh?” Most people didn’t dramatically shift their allocations…at least, not then.  But the following year, Canadian stocks beat U.S. shares again— by more than 12 percent.

Ten years later, it was common to hear Canadians say, “Why would anyone want U.S. shares?” To their eye, it was like betting John McEnroe would win Wimbledon again. 

Canadian stocks had trounced the S&P 500 in 1999, 2000, 2002, 2003, 2004, 2005, 2006, 2007, 2009 and 2010.  In fact, if someone invested $10,000 in the Canadian stock market index in January 1999, it would have grown to a whopping $26,729 by December 31, 2010, in Canadian dollars.  In contrast, if someone invested $10,000 over the same time period in the S&P 500, it would have been worth just $8,206, measured in Canadian dollars. 

Dan Bortolotti is a Certified Financial Planner who builds portfolios of ETFs for Canadian clients.  In his upcoming book, Reboot Your Portfolio, he says, “In the years following the 2008-09 financial crisis, it was common to see Canadians holding 100 percent domestic [Canadian] stocks and arguing passionately that there was no reason to look beyond our own borders.” 

Over the next ten years, Canadians whose allocations drifted started waking up to find themselves naked.  Many had little U.S. stock exposure.  That meant they weren’t globally diversified, and when U.S. stocks took off, they were left without their pants.  From January 2011 to December 31, 2015, Canadian stocks averaged a compound annual 2.32 percent per year while U.S. stocks recorded 20.26 percent per year (measured in Canadian dollars). At this point, plenty of Canadians began to say, “To heck with Canadian stocks. They suck!  I’m loading up on U.S. shares.”

Twenty-nine-year-old, Neil Draper became one of them.  He began adding to a globally diversified portfolio of index funds in 2015.  But over time, he added an increasing amount of money to his U.S. stock market index. “The U.S. index was doing better than all of them,” he says, “so when I added money to my account each month, I just kept adding to the best-performing index.” After six years of adding money, he sold his bond market holding.  “It wasn’t going anywhere, so I decided to get rid of it and keep adding to U.S. stocks.”

Plenty of Americans, perhaps even most Americans, are doing much the same thing.  They’re adding more money to U.S. stocks while ignoring international markets and bonds.  One investor emailed me to say, “I began with an allocation of 60 percent stocks, 40 percent bonds, but I’ve changed it to 100 percent stocks because I realize my tolerance for risk is higher than I thought.”  That’s like someone rowing downstream in a boat and saying, “Rowing upstream would be easy because look how fast I’m going.”

U.S. stocks haven’t dished out pain since 2008, and we can’t gain an epiphany about our tolerance for risk when stocks keep going up.

What wins this year or this decade, won’t likely be the winner over the next ten years.  By chasing past winners, we end up buying high and (often) selling low.  We drift from a disciplined allocation.

This is why I’m a huge fan of asset allocation index funds.  Each is a fully diversified portfolio wrapped up into a single fund, so investors don’t have to select what index fund to buy in any given month or year.  A fund manager rebalances the internal holdings to maintain a consistent allocation.  When investors in such funds look at their portfolios, they can’t tell which markets are soaring and which might be lagging.  That’s why, according to Morningstar, most investors in such funds tend to behave well.  In other words, they rarely buy high and sell low because they aren’t tempted by the isolated performances of individual indexes. Instead, they typically keep their money on autopilot, and nobody chases a rising asset class.

If you’re looking for a low-cost asset allocation fund, consider one of Vanguard’s, Schwab’s or Fidelity’s Target Retirement funds.  They maintain a consistent allocation, slightly increasing their bond allocations over time.  Or you could select one of Vanguard’s LifeStrategy funds. These never shift from a consistent allocation.

Such funds prevent asset allocation drift…savings investors from themselves and an embarrassing naked run.

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