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moneysense.ca, 12/03/09
Increasing equity allocation in severe bear markets
Responding to an earlier post, a few readers have wondered if I have considered increasing the equity component of the portfolio in a severe bear market, a tactic gingerly suggested by William Bernstein in The Four Pillars of Investing (read review):
Ideally, when prices fall dramatically, you should go even further and actually increase your percentage equity allocation, which would require buying yet more stocks. This requires nerves of steel and runs the risk that you may exhaust your cash long before the market finally touches bottom. I don’t recommend this course of action to all but the hardiest and experienced of souls. If you decide to go this route, you should increase your stock allocation only by very small amounts — say by 5% after a fall of 25% in prices — so as to avoid running out of cash and risking complete demoralization in the event of a 1930s-style bear market.
I did consider trimming back the allocation to bonds after a severe decline but haven’t acted it. It’s just that I’m not entirely comfortable making tactical changes to asset allocation even when it makes perfect logical sense.
moneysense.ca, 12/03/09
I personally think it is important to stick with your original investment policy unless your circumstances have changed. Too often people change their asset allocation because they want to take advantage of opportunities or believe a market correction is coming.
Although I think there is a great amount of value, sticking to your original plan I believe is more important.
[...] Some great bear market investing tips in this post. [...]
[...] Some great bear market investing tips in this post. [...]
Back in December, I gave in to temptation and increased my stock allocation and decreased my bond allocation. In retrospect, I’m not sure that I should have done that. Is this not another form of market timing?
Its not market timing when you do it as part of your regular rebalancing strategy. In that case, it is definitely a valuation decision, something the indexer normally also try to avoid.
It IS market timing if you do it as Berstein suggests. But, I don’t completely subscribe to the “All Market Timing is Bad” school. Like Buffet says, “The time to be greedy is…”.
I’m doing this right now.
CCs rebalancing spreadsheet ensures he buys more equities when they are low. He correctly determines he is not comfortable with such a move despite the “logic” of it.
When considering whether to increase equity allocations after a large drop, one must understand that this action involves an increase in the risk level of the portfolio (not only because equities are higher risk, but also because you are now introducing enhanced cash flow effects). As with any extra risk taken, you will either have biggers wins with it, or bigger losses.
Certainly after a 25% drop, I would argue that the risk return parametres of such a move become more compelling (hence the “logic”); however, the fact remains this is a risk-increasing strategy and the results – good or bad – will simply be attributed to the extra risk taken on.
If you add more equities because of market drop to return to your ORIGINAL asset allocation target, that is one thing.
But what Bernstein is saying is that you should INCREASE your equity target.
If you have a 65% equity 35% income allocation and markets dropped by 25% and now you have 50% equity when you rebalance yo go back to 65%, in Bernstein strategy you would now increase that from 65% to 70% equity.
Rebalancing is an regular part of investment, but altering your asset allocation is taking on more risk and diverting from your established targets and taking on more risk.
Not going to tinker with it – I’m 60-40 equities-fixed, and I am adding regularly to the equities since they’re the ones that keep shrinking below allocation.
Why does every keep saying that equities are now “cheap”? Cheap compared to what? Trailing 52-week P/E ratios? Well, I’m sorry to tell you, the “E” has fallen off a cliff. Cheap compared to the 52-week high? Yes, but the stock market gods don’t remember the price where you got in and they won’t guarantee that it will go back there when the crisis is over. Cheap compared to book value? Well, book value has probably fallen since the last report as real estate, commercial paper and other assets have plummeted in value.
Perhaps the reason why stocks are “cheap” is because this what they’re SUPPOSED to be trading at based upon forward earnings and asset values?
Phil S: I understand what you mean, but cheap compared to historic prices, banks are at single digit multiples you havent seen that in years. Also cheap compared to their “normal” earnings I know this is a little far stretched but if you holding it for long terms a reasonable assumptions is that the company will be able to return to their “normal” earnings at which point the current p/e would be even lower.
I agree “E” has fallen but so has “P”, and for many good companies their price/book value is very low, you can pick up some companies at their book value.
Running out of cash could be a concern if a decline continues for too long, but that shouldn’t happen unless you change your allocation blindly.
I believe it was The Four Pillars that explained why expected returns in the earlier part of this decade were lower than historical returns because of the bull market of the last 20 years (prices won’t keep rising forever if you buy at an unusually high price). Now that a good part of its effects have been reversed, the expected returns for equities should be higher than they were a few years ago.
Based on this you can go back to the reasons you chose your original allocation (it is based on relative risk and return, right?). If the expected return for equities is higher than before you might increase the allocation, but not to the point where you have nothing else. With this new allocation you can rebalance to get the performance and risk that you want in the future.
Dumping money into the market just because it went down is ordinary market timing (unlike chasing performance it has a chance to work). Coming to new conclusions because the information they’re based on has changed can be a wise move if you don’t let your emotions affect the results. If you can’t avoid that you might want to stick to age-based allocations.
It is interesting that Jack Bogle increased the bond proportion of his portfolio back in 2000. He felt that stocks were overvalued. Is that market timing? Of course, he is Jack Bogle. By most measures, stocks haven’t been this cheap in more than 10 years. For a long term investor, the return on your investmen by putting money in stocks will most likely be greater now than any time in more than a decade.
Typically when the strategic asset allocation is set, the targets are set as a range. If you targeted 50% equities, we would expect to see a tactical range such as 40-60%. Allowing the allocation to move within the range, up to 60% would not be considered a violation of the strategic allocation. It is a conscious decision to take on additional risk, but is still within the scope of the initial strategy. The range can also be used as a rebalancing guideline if you wish to avoid the calandar based rebalancing strategy. If you “bail” on the strategy and violate the tactical envelope then you are consciously moving to a new strategic allocation and should revisit your Investment Policy Statement.
[...] Canadian Capitalist talks about Increasing equity allocation in severe bear markets [...]
[...] Canadian Capitalist wrote about increasing equity allocation in severe bear markets. [...]
If you DO NOT change the balance of your allocated assets, they you are not really allocating assets.
What you did was choose initial investments and plan to hold them forever.
Find the courage.
Mark
Mark: I’m not sure I entirely understand your comment. My plan is not to set an initial allocation and never make any changes. It is to rebalance to the original allocation percentages periodically, typically by adding new money and occasionally by rebalancing. What I considered was increasing the equity allocation from my current 80% to 85%, after a severe drop in the equities. I did not make any change.