The majority of mainstream financial literature advocates an asset allocation strategy that accounts for neither interest rates nor market valuation levels. (The most common suggestion being the “age in bonds” rule of thumb.)
But common sense tells us that, all else being equal, the stock market is a better buy when it has a P/E ratio of 12 than when it has a P/E of 18. Similarly, all else being equal, it’s better to buy a given bond index fund when it’s yielding 5% than when it’s yielding 3%.
So how might one go about capitalizing on such fluctuations?
Benjamin Graham, author of The Intelligent Investor (probably the most-respected investment book ever written), has one suggestion. He advocates:
- Using a 50/50 stock/bond allocation as a baseline, and
- Shifting as far as 25/75 in either direction, based upon current market conditions.
Graham explains it this way:
“The sound reason for increasing the percentage in common stocks [beyond 50%] would be the appearance of ‘bargain price’ levels created in a protracted bear market. Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgment of the investor the market level has become dangerously high.”
Seems reasonable to me.
Implementing Graham’s Suggestions
The tricky part is the actual implementation. For example:
- What, exactly, constitutes “bargain price” levels? And what price level would be “dangerously high”?
- How often should you check market valuations to see whether you should adjust your current allocation?
- To what extent should you shift your allocation based on a given degree of change in market valuations?
Bob Davis, one of the authors of The Bogleheads’ Guide to Retirement Planning, provides one method. He suggests comparing the current earnings yield of the stock market to the current yield on the bond portion of your portfolio — keeping a 50/50 allocation when the two yields are the same, and shifting slightly toward whichever yield is higher when they’re unequal.
Another Boglehead author, The Finance Buff, follows a plan of “overbalancing.” That is, rather than periodically rebalancing to a target asset allocation, he rebalances beyond his baseline allocation based on changes in market valuations.
Why Not Use Such a Strategy?
Given the common-sense appeal of accounting for price levels and interest rates when investing, why would you not want to implement such a strategy? I can think of four reasons.
First, as Graham puts it, “A program of [this] kind is not especially complicated; the hard part is to adopt it and to stick to it.”
It’s hard to move to a particularly stock heavy allocation right when the strategy calls for it (i.e., right after a market crash — when the economy looks the bleakest). And it’s hard to move money out of stocks right when they’re performing their best.
Second, while such a strategy isn’t particularly laborious to implement, it’s certainly more work than rebalancing once each year to a given asset allocation.
Third, once you’ve decided that you’re more clever than the market in one area (overall valuations, in this case), it’s tempting to start thinking you’re more clever in other ways as well. This can be dangerous. While the market’s not perfect, it’s a lot smarter than it looks.
Finally, there’s the simple fact that you might be wrong. While the market may look underpriced at a given price level, it’s entirely possible that it will continue to go down, for reasons you could not have predicted. And, therefore, moving a greater percentage of your portfolio into stocks would turn out to be a mistake. (And, of course, an opposite mistake can occur when deciding the market is overpriced at a given point in time.)