Dealing With Shades of Gray in My Allocation

Special note: On behalf of everyone at AAII, happy (early) Veteran’s Day to those of you who served in the military. Thank you to everyone who has or is currently serving.

I conducted my semiannual review of my 403(b) retirement account yesterday. In doing so, I noticed that the account’s allocation had entered the gray zone between not having to act and being close enough to justify taking action.

As longtime readers of this weekly commentary know, I look at my 403(b) account at the end of May and the end of October to determine if any rebalancing is needed. These months represent the start of the worst six months (May) and the start of the best six months (November) for the stock market. I’m a week late this year, but that’s minor in the grand scheme of things.

Many of you also know that we at AAII believe in following a consistent, well-defined approach to investing. This is a massive component of successful portfolio management.

Even within the context of preset rules, there can be opportunities to “sin a little.” I’m facing one of those situations right now.

I use a quasi-equal-weighted allocation for my 403(b) account. The target allocation for each of the funds held in it is 20%. Because investing is messy and winners should be allowed room to run, I only rebalance when the weighting of one or more of the funds rises above 25% or falls below 15%.

Here is what Vanguard showed the account’s allocation to be as of Tuesday’s close:

• Vanguard 500 Index Admiral fund (VFIAX): 24%
• Vanguard Small-Cap Value Index Admiral fund (VSIAX): 21%
• Vanguard FTSE All-World ex-US Small-Cap Index Admiral fund (VFSAX): 18%
• Vanguard Real Estate Index Admiral fund (VGSLX): 18%
• Vanguard Intermediate-Term Investment-Grade Admiral fund (VFIDX): 19%

Vanguard 500 Index Admiral’s allocation is close to the level where rebalancing would be needed. Rebalancing now would reflect the spirit of the strategy but not a strict interpretation of the rules. In other words, a gray area now exists that allows me some leeway in deciding whether to act or not. Chances are many of you have encountered such a situation too.

One factor tipping the scale in favor of not acting—besides adhering more strictly to the rules—is the market’s seasonal pattern. The best six months of the year, as defined by the Stock Trader’s Almanac, started last week. The S&P 500 index has realized an average 6.6% return between November and April since 1945. Sam Stovall of CFRA Research says the average return has been slightly higher at 6.7% since 1990. Small-cap stocks and international stocks have fared better during this period of the year.

If I really wanted to sin, I could solely boost the exposure to the small-cap and international funds at the expense of others, given Stovall’s table. This would go beyond the gray area of my strategy and into one that is clearly tactical. Allowing some room for leeway is fine; abandoning the spirit of the strategy is not.

I’m adhering to a long-term allocation strategy designed to favor growth of capital with rules for rebalancing when exposure to one or more asset class category veers too far from the target. The approach is designed for the constraints I face with my 403(b)—meaning the use of Vanguard mutual funds, which isn’t a bad thing—my personal tolerance for volatility and my investing time horizon. Your approach may well be different. That’s fine as long as it is clear when you will act, when you won’t and where any boundaries regarding some subjectiveness exist.