The most important benefit of a tactical asset allocation strategy is the flexibility to have a conservative asset allocation plan when valuations are high. Why did I emphasize a conservative asset allocation when valuations are high and not an aggressive asset allocation when prices are bargains? Both are major benefits, but I want to make the point that it is more important to have a conservative asset allocation plan when valuations are high because it is more important to not lose a large percentage of a portfolio than it is to capture the gains of a rising market.
Many investors have experienced the harm done to their portfolio when they have lost large percentages. If investors lose 50% of their portfolio, it takes a 100% gain to get back to breakeven. If you lose 10% of your portfolio, it only takes an 11% gain to get back to breakeven. One of the bedrock principles every investor should have is to preserve capital in bear markets for investment at lower prices. The laws and rules of compounding make this crucial to successful investing over a lifetime.
Why a Conservative Asset Allocation Plan Now
Once an investor understands that asset allocation targets should be different depending on valuation, the next step is to determine whether valuations are high or low. Let’s take a look at the two major asset categories most investors hold in their portfolios.
Investing in Bonds
Bond Prices are high and Bond Yields are Low. Here is a long term chart of the 10 Year Treasury Yield which shows bond yields have been declining; meaning prices rising for over 30 years! How much lower can they go? How much risk is there that they could reverse and prices move significantly lower than they are currently? The Case Against Bonds is compelling.
Investing in Stocks
The long term valuation metrics for investing in stocks are now at cautionary levels at best. The S&P 500 Dividend Yield at 1.77% is near extreme lows; far below average historical yields. When interest rates increase this will be tremendous competition for low dividend yields.
The S&P 500 PE Ratio, using the Shiller PE10 (which averages inflation adjusted earnings over 10 years), is at levels that have historically produced minimal or negative long term returns.
Jeremy Voh, owner of the Generation X Finance Blog, has written a great article about this subject. For those of you who are interested, it is worth the 10 minute read. But at least take a quick look at “This is Why You Can’t Make Money in the Stock Market”.
Conservative Asset Allocation Investing
The current investment environment is particularly tough; especially for investors who have already been burned and let their emotions control their investment decisions. Reactions usually come in one of two ways; inaction or decision to not take risks, or wait and buy at the top or sell at the bottom.
The best strategy is to take a balanced approach and invest more aggressively when prices are low and lower your asset allocation when assets are high. This means not looking at what and how others are doing. They are usually part of the crowd and will only tell people when they are doing well.
Valuation is the key ingredient to successful investing in common stock. We only want to make investments that offer enough reward to warrant taking the risk. Sometimes that means holding considerable amounts of cash when the market is high.
Related Reading: “Preservation of Capital and Allocation of Assets”
| AAAMP Blog by Ken Faulkenberry | |
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Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
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