Portfolio asset allocation is perhaps the single most important decision you could make as an investor. It doesn’t matter whether you are a passive buy-and-hold investor, an active investor, or even a trader who uses aggressive quantitative strategies. In all cases, the foundation for long term success lies in money management and how you allocate your funds between assets and strategies. The underlying purpose is to manage risk at all times and under all market condition.
This is because no matter how well your investments happen to be doing at the time, it is pretty much guaranteed that things will not go your way sometime in the future. In fact, it’s likely that things won’t go your way much of the time. So when the market proves you wrong, you want to make sure you can take the blow without drawing blood in the battle. This goes back to how much of your funds are truly at risk. Sound cash management and allocating your funds between uncorrelated asset classes and strategies is paramount to maintaining risk at an acceptable level.
There are many ways in which you could allocate funds in your portfolio. You’ve most likely heard about strategic and tactical asset allocation. Investopedia proposes 6 different ways to allocate, and all of them are some variant of strategic and tactical allocation. I will propose yet another way, based on rules and statistics.
Strategic Asset Allocation
But first, let’s be clear on the basics. Strategic asset allocation is the most fundamental way to allocate and it should take your personal situation and investor personality as its starting point. Part of your financial advisor’s job is to get to know you as an investor, especially how you react to major market events. This is an elaborate topic in and of itself. But suffice it to say that it is the starting point and is what makes a (good) advisor truly worth her fees. By combining these behavioral elements along with other facts about your financial situation (income needs, cash, life stage, major upcoming expenses, etc.) your advisor can take the next step. This usually takes the form of a high level allocation recommendation between major asset classes along with a true sense of your risk profile. In one of its simplest forms, a strategic allocation can look something like this:
In some cases, strategic allocation can go into further details within each major asset class to include foreign equities, real estate, commodities or alternative investments. Then, at regular intervals (typically once a year), you rebalance your portfolio to ensure you maintain your target allocation.
Tactical Asset Allocation: Not Without Flaws
Strategic allocation provides a nice foundation but it lacks flexibility for someone who takes a more active role to portfolio management. Tactical allocation addresses this lack of flexibility by allowing deviations from the allocation target. For example, you may decide to buy more bonds or even gold at the onset of economic or financial market stresses (2008). Conversely, you may want to own more equities during a bull market. Being opportunistic in this way makes sense but it is also fraught with perils. This is because most investors tend to overweight equities near the top of an equity bull market (everyone is ecstatic) while selling those equities to buy bonds at the peak of the market crisis which usually corresponds to the bottom of the equity bear market. In other words, they buy high and sell low and therefore greatly reduce their portfolio returns.
This is why many advisors are adamant about sticking to a strategic allocation scheme only. Then, they try to be systematic with their clients by ensuring the portfolio is rebalanced regularly, thereby doing a mild form of buy low and sell high.
Consider Rules-Based Tactical Allocation
One way to address the pitfalls of tactical allocation is to use a statistically proven set of rules that allows you to deviate from your target allocation in a systematic way. The rules could tell you to buy low and sell high, or they could tell you to sell an asset class that is about to get in trouble. For example, you could have a rule that tells you to sell some bonds and buy stocks during a financial market stress event, such as what Warren Buffett did when he bought Goldman Sachs stock in 2008.
Of course, this is easier said that done. As a starting point, your rules-based allocation must consider at least two very important issues:
- The Rules Must be Statistically Proven. The rules must have been statistically demonstrated to work most of the time. Of course, no rule is a crystal ball, so it is foolish to believe that any rule will be right 100% of the time. But if you can demonstrate, through a careful and thorough statistical analysis, that it works for a meaningful percentage of the time, then it may be worthwhile to use it for part of your portfolio. However, beware of statistical tricks and financial charlatanism.
- It Must fit Your Investor Personality. Do you have the personality to follow the rule when it tells you to take action? Remember that the rule is based on statistics so it can never be guaranteed. But if it’s been shown to work most of the time in the past, then will you follow it when the rubber hits the road? This is important because if you hesitate or second guess your rules at the worst time, it could be costly. In this case, developing specific scenarios may be quite helpful.
To Use or Not to Use: That is the Question
If you are uneasy about a specific rule that is otherwise compelling, then what should you do?
One approach is to use your rule with a small commitment of capital (say, 2%, 5% or 10% of your portfolio as appropriate). For example, consider the Golden Cross market timer. As a way to boost returns, the golden cross timer has a mediocre track record because it often gets caught in market whipsaws. However, it has managed to correctly get investors out of equities in the last two major bear markets (2001 and 2009), greatly reducing portfolio drawdowns in the process. So should it (or some other/better market timer) be worth some consideration?
In many cases, the answer is yes provided you use this timer to shift a small portion of your target allocation between bonds and stocks. In this case, the benefits would be a meaningful reduction of portfolio drawdowns during major bear markets, while the cost may be a tiny drag on returns, all else being equal. For many of us, this trade-off may be worth it.