From the Archives: Getting Going

Balancing Act: Trying to Make Money
Whether the Market Goes Up or Down

By JONATHAN CLEMENTS
Staff Reporter of THE WALL STREET JOURNAL

If you ask a stupid question, you will get a stupid answer. Today's stupid question: Which way is the market headed next?

Sure, we all want to know if stocks are breaking out of their recent funk and whether bond yields will rise or fall. Problem is, this crystal-ball gazing is a colossal waste of time.

It isn't simply that the pundits -- professional and amateur -- often get it wrong. More important, the whole exercise is totally unnecessary. The reality is, you don't need to guess the market's direction in order to profit from shifting valuations. Instead, all it takes is a little self-discipline. Intrigued? Bear with me while I explain.

Guessing games. No, I am not arguing that you should ignore stock and bond valuations. In fact, I think it's important to have some sense for whether the market is expensive or cheap, because that has a big impact on long-run returns.

And right now, current valuations suggest returns will be modest. A mix of high-quality bonds might yield a paltry 5%. That's a good indicator of bond returns for the decade ahead.

Meanwhile, to get a handle on stock returns, you need to consider both earnings and dividends. If inflation runs at 2½% and corporate America does a decent job during the next decade, we might get 5½% annual growth in earnings per share. Tack on an extra 1½% for dividends, and we are looking at 7% annual stock returns.

This 7% assumes stocks hang in there at their current 21 times earnings for the past 12 months. If price/earnings multiples contract, returns could be a lot lower. Either way, performance isn't going to be great, so you probably ought to save aggressively to compensate.

This long-term forecast, of course, shouldn't be confused with a short-term market prediction. Nobody knows how stocks and bonds will fare during the weeks and months ahead. Which brings me to a recent, humbling experience.

On April 21, I opined, "I don't think this is the moment to load up on real-estate investment trusts." The article focused on valuations among equity REITs, which make their money by buying and then renting out shopping malls, apartments, office buildings and other properties. With equity-REIT yields close to their all-time low, I argued that REITs were unlikely to deliver decent long-run gains.

I still think REITs are expensive, and I still think I am right about the long term. But I sure haven't been right so far. Since the article appeared, equity REITs have jumped 8%. Painful? It only hurts when I write.

Goosing returns. So if you cannot forecast the market's short-term direction, what should you do? My advice: Forget trying to predict the unpredictable -- and instead take advantage of this unpredictability. And the way you do that is with rebalancing.

Start by setting target percentages for your various holdings. You might settle on a mix of, say, 5% money-market funds, 10% high-quality corporate bonds, 10% inflation-indexed Treasury bonds, 5% high-yield junk bonds, 30% large-company U.S. stocks, 15% small-company stocks, 5% real-estate investment trusts, 15% developed-foreign-market stocks and 5% emerging-market stocks.

Once you have built your desired portfolio, you should then rebalance once a year to bring your investment mix back into line with your target percentages. Suppose you allocated 5% to REITs and the sector continues to soar. When you next rebalance, you would want to prune your REITs back to 5%.

In your retirement account, you can rebalance by shifting money out of winning sectors and into the losers. But in your taxable account, this sort of trading is a bad idea, because you could trigger hefty tax bills. Instead, to keep your taxable account in balance, funnel your dividends, interest and any new savings into your portfolio's underweighted sectors.

What's the point of all this? The principal goal is risk control. By scaling back winners, you ensure your portfolio doesn't become dangerously overweighted in any one sector.

But as an added bonus, rebalancing offers a disciplined strategy for making money from market gyrations. The reason: It forces you to buy into depressed sectors that may be due for a rebound, while lightening up on highflying sectors that could be set to tumble.

"Rebalancing is just a nice reliable way of betting against the noise and betting on mean reversion," says William Bernstein, an investment adviser in North Bend, Ore.

The impact on your portfolio's performance will vary. For instance, rebalancing between stocks and bonds is great for risk control, but it may not boost your long-run returns, because you will usually be forced to sell stocks, thus cutting back on your portfolio's best-performing investment.

On the other hand, you can garner a sizable performance bonus by rebalancing among a collection of stock-market sectors that generate fairly similar long-run returns. For proof, consider some numbers from T. Rowe Price Group Inc., the Baltimore mutual-fund manager. I asked the folks there to calculate the return on a portfolio with 50% U.S. stocks, 25% foreign shares and 25% REITs.

If you had invested $10,000 in that portfolio 30 years ago and never rebalanced, you would have accumulated $347,000 by year-end 2003. But if you had rebalanced back to your 50-25-25 mix once a year, you would have amassed $390,000. And here's the impressive part: To pocket that extra $43,000, you didn't once have to guess the market's direction.