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The Most Important Choice That A Stock Investor Makes

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I’ve heard it said that the most important choice that an investor makes is the amount of his stock allocation.

I can see it.

Choices That A Stock Investor Makes

Stocks pay higher returns than other investment options. An investor who goes with too low of a stock allocation is going to limit his returns dramatically and thereby will limit his chances of achieving a comfortable retirement at an acceptable age. On the other hand, stock price crashes can be scary. An investor who goes with too high a stock allocation may thereby cause himself to go into freak-out mode during a price crash and thereby to lock in losses that may reduce his lifetime return in a significant way.

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You’ve got to get it just right. You don’t want your stock allocation to be too low and you don’t want it to be too high. And it’s not easy to get the stock allocation percentage just right. Stock returns are all over the map. It is possible that in the years following the day you make the choice that stock returns will be wildly good or wildly bad. You can’t even look at recent performance for clues. Good return years are often followed by poor return years and poor return years are often followed by good return years.

So I am largely in agreement with the claim that it is her stock allocation that is the most important choice made by an investor.

But I am not in complete agreement. I think that there is another choice that is even more important. The most important choice that an investor makes is how much she is going to engage in market timing in response to valuation shifts.

Stock Allocation Percentage

The usual way that investors decide on a stock allocation percentage is to look to the rule of thumb that suggests that they go with 60 percent stocks, 30 percent bonds and 10 percent cash. Most investors don’t follow the rule-of-thumb precisely. Investors who feel that they can afford to take on more risk than most go with somewhat higher stock allocations and investors who feel that they are more sensitive to losses than most go with lower stock allocations. But most have the rule-of-thumb in mind when they make their decision.

It’s a reasonable rule of thumb. The idea behind it is that investors cannot avoid risk and expect to be able to retire at a good age and that they cannot take on excessive risk either. Going 60-30-10 as a general rule makes sense.

There’s one big problem with the scheme, however. The conventional rule of thumb ignores Robert Shiller’s Nobel-prize-winning research showing that valuations affect long-term returns and that therefore stock investing risk is not stable but variable. If stock investing risk varies with changes in stock valuations, investors who want to maintain a constant risk profile must adjust their stock allocation in response to valuation shifts to do so. There is no one stock allocation that can make sense at all valuation levels.

CAPE Value

I have adapted the conventional rule-of-thumb to reflect what we have learned from Shiller’s “revolutionary” (his word) research. I would propose that investors go with a 60 percent stock allocation when prices are moderate (when the CAPE value is higher than 12 and lower than 22), a 30 percent stock allocation when the CAPE value is higher than 21 and a 90 percent stock allocation when the CAPE value is lower than 12). That’s the same basic stock allocation over the course of an investment lifetime but one that aims to “stay the course” in a meaningful way (not by sticking with the same stock allocation at all times but by sticking with the same risk profile at all times).

It makes a big difference.

A regression analysis of the historical return data shows that the most likely 10-year annualized return when the CAPE value is 8 (as it was in 1982) is 15 percent real while the most likely ten-year annualized return when the CAPE is 44 (as it was in 2000) is a negative 1 percent real. Is there any case for going with the same stock allocation at a time when the most likely return is 15 percent real as when the most likely return is a negative 1 percent real? If there is, I sure am not able to imagine it.

Investors need to try as hard as they can to get their stock allocation right. But they need to abandon the idea that there is one choice that makes sense in all valuation environments. The difference in returns obtained when valuations are low from the returns obtained when valuations are high is so great that we might as well be talking about two different asset classes. The thought that one stock allocation choice could work at all valuation levels makes about as much sense as the thought that one driving speed could work both when the roads are dry and clear and when the roads are snow-covered and icy. No one drives at the same speed in all conditions. No one should go with the same stock allocation in all conditions.

The idea of getting one’s stock allocation right is to manage risk and return. Being too afraid to take on risk will reduce your return too much for you to achieve your long-term investment goals. It is not possible to make an intelligent choice without taking valuations into consideration because valuations affect both returns and risk. Ignoring the most important factor makes the management project an impossible one.

The thing that puzzles me is how the idea that there might be a single allocation choice that could work at all valuation levels ever became conventional wisdom. I think it is the core idea behind Modern Portfolio Theory – that investors are engaged in the rational pursuit of their own self-interest – that is to blame. If investors were rational, investors would not be willing to take on more risk without the promise of obtaining higher returns for doing so. The reality, of course, is that most investors behave in just the opposite way; investors love to invest heavily in stocks when risk is off the charts and when likely returns are miniscule and investors flee stocks when risk is minimal and likely returns are off the charts.

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