Get new posts by email:

Behavioural Issues with Variable Asset Allocation

I recently adopted a specific type of dynamic asset allocation for my personal portfolio.  I call it Variable Asset Allocation (VAA).  It only deviates from my original long-term plan when the world’s stocks become pricey, but any time you change your long-term investing plan, there’s the possibility you’re just looking for a smart-sounding justification for giving in to your emotions.

It’s certainly true that I’ve been concerned for some time that stock prices are high and that the chances of a stock market crash have been rising.  But I know better than to join the chorus of talking heads predicting the imminent implosion of the stock market.  I don’t know what will happen to stock prices in the future.

I’m not tempted to just sell everything and wait for the crash.  It’s possible that stocks will keep rising, and when they finally do decline, it’s possible they’ll remain above today’s prices.  It must be sickening to wait for a crash that doesn’t happen.  This would have been the fate of someone who decided 5 years ago that prices were too high and sold out.

Whenever an investor sells completely out of stocks, the problem is when to get back in.  Sometimes, it’s a significant market decline that causes investors to sell all their stocks in fear.  Then they have to decide when it feels safe enough to buy back in.  Too often, they wait until prices are much higher than when they sold.  The same thing can happen to those who sell because they think stock prices are too high.  They can sit in cash waiting for the big crash that never comes.

So, could some form of this happen to me with my VAA?  The answer is no, but only if I follow VAA strictly.  With VAA, if my portfolio’s blended Cyclically-Adjusted Price-Earnings (CAPE) ratio exceeds 25, I add CAPE minus 25 (as a percentage) to my bond allocation.  For example, when the blended CAPE of my portfolio sits at 32, I add 32-25=7 percentage points to the bond allocation I would have had if the CAPE were below 25.

If stock prices rise, the CAPE rises, and if my bond allocation rises enough to trip my rebalancing threshold, I rebalance from stocks to bonds.  However, given that I’ve chosen to adopt VAA, selling stocks is easy because that’s what my emotions are already telling me to do.

What if stock prices go down by just enough to trip my rebalancing threshold?  VAA would have me buy back some stocks.  But what if I’m still nervous about owning too many stocks?  I might delay rebalancing, or worse, I might tinker with my VAA rules so that I don’t have to buy stocks.  This is the danger of constantly tinkering with long-term plans.  Even if each change has a smart-sounding reason, I might really be just giving in to emotions.

So, the real test of whether my switch to VAA is a fixed long-term plan will come if stock prices drop enough that my spreadsheet calls for rebalancing from bonds back to stocks.  I admit that when this happens, I likely won’t feel good about buying stocks, but my intention is to obey the spreadsheet.

<< Previous Post Next Post >>

Comments

  1. AnonymousDecember 20, 2021 at 8:07 AM

    What is your exit strategy?

    ReplyDelete
    Replies
    1. Michael JamesDecember 20, 2021 at 9:22 AM

      Anonymous,

      My strategy has no exit. I spend from my cash position and rebalance my portfolio whenever the VAA-informed formulas require it. Perhaps I'm not following your question.

      Delete
  2. AnonymousDecember 20, 2021 at 11:14 AM

    Hypothetically, if the market tanks again (e.g. 30% decline in a few weeks) a la March 2020, will you not sell some/most of your bond position and increase your equity allocation even if CAPE is > 25 (as it was with March 2020)?

    ReplyDelete
    Replies
    1. Michael JamesDecember 20, 2021 at 11:46 AM

      Anonymous,

      Yes, in that scenario, my bond allocation would rise due to the drop in stock prices, my target bond allocation would drop based on VAA calculations, and my spreadsheet would call for rebalancing from bonds to stocks. If I actually performed this rebalancing then I'd pass the behavioural test I described in this article.

      Delete
  3. GarthDecember 20, 2021 at 6:09 PM

    Hi Michael

    That sounds like a fair and reasonable thought process. Managing our own behavior as investors is still the biggest challenge we face. The fact that you have a publicly written record of your thoughts and decisions should prove to be helpful for accountability. Thanks for sharing.

    ReplyDelete
    Replies
    1. Michael JamesDecember 20, 2021 at 7:16 PM

      Hi Garth,

      We'll see whether these are just lofty goals or whether I'll stick to my plans. Increased accountability is definitely what I'm aiming for.

      Delete

Post a Comment

Popular posts from this blog

Short Takes: InvestorLine’s HISAs, 24-Hour Trading, and more

I recently moved some cash into BMO InvestorLine’s high-interest savings accounts (HISAs) that are structured as mutual funds.  Their designations are BMT104, BMT109, and BMT114, and they purportedly pay 4.35% annual interest (which they can change whenever they like).  However, the way they report the monthly interest payments is so baffling that I wasn’t able to sort it out in my first 15 minutes of trying.  A further complication is the following text in the HISA description: “The Bank may pay, monthly or quarterly, compensation to your Dealer at an annual rate of up to 0.25% of the daily closing balance in the BMO HISA.”  I couldn’t find any evidence of such a charge, but I haven’t been invested for a full quarter, and I can’t yet say that such a charge isn’t buried somehow in the confusing reporting.  I have more digging to do before I can recommend these HISAs. Here are some short takes and some weekend reading: Preet Banerjee explains the dangers of Robi...
Read more

My Asset Allocation

I’ve resisted discussing my asset allocation for some time, but now is finally the time to describe it and the reasons behind it. I’m not holding it out as a model portfolio; I believe it’s suitable for me and not necessarily anyone else. With that warning, enjoy the discussion and feel free to ask questions or take some pot-shots. The main reason why I haven’t discussed my asset allocation in detail before now is that I don’t want readers to treat it like a model portfolio and follow it blindly. Everyone’s situation is different. The need for variation in asset allocation from one investor to the next usually isn’t huge, but there is no one-size-fits-all portfolio. A secondary reason for keeping my asset allocation to myself is that I can’t be sure I’ll never change it. For example, I recently made the minor change of switching from an ETF of small-cap stocks to an ETF of small-cap value stocks . I don’t have any plans to change my current allocation, but I may think differe...
Read more

What to Do About Crazy Stock Valuations

Image
The last time I had to put a lot of effort into thinking about my finances was back when I retired in mid-2017.  I had ideas of how to manage my money after retirement, but it wasn’t until a couple of years had gone by that I felt confident that my long-term plans would work for me.  I had my portfolio on autopilot, and my investing spreadsheet would email me if I needed to take some action. I was fortunate that I happened to retire into a huge bull market.  I got the upside of sequence-of-returns risk.  The downside risk is that stocks will plummet during your early retirement years, and your regular spending will dig deep into your portfolio.  Happily for me, I got the opposite result.  My family’s spending barely made a dent in the relentless rise of the stock market. However, stock prices have become crazy, particularly in the U.S.  One measure of stock priciness is Robert Shiller’s Cyclically Adjusted Price-Earnings (CAPE) ratio .  In the U.S...
Read more

Archive

Show more