The standard Buy-and-Hold stock allocation advice is that investors should go with a portfolio of 60 percent stocks, 30 percent bonds and 10 percent Treasuries. I don’t agree with the idea that one’s stock allocation should be a constant. Shiller showed that valuations affect long-term returns.
So an investor seeking to keep his risk profile constant over time needs to engage in market timing. It makes more sense to go with 60 percent stocks when prices are reasonable, 90 percent stocks when prices are at rock-bottom lows and 30 percent stocks when prices are at sky-high scary levels.
Q3 2022 hedge fund letters, conferences and more
So I think that the 60/30/10 breakdown is sensible so long as the CAPE value has not strayed too far from the fair-value level of 17.
However, my experience in talking these matters over with thousands of middle-class investors in internet discussions held over the past 20 years is that, in an environment in which the importance of market timing is not being regularly stressed, investors will interpret the conventional advice in all sorts of unfortunate ways.
The Importance Of Market Timing
The problem is that the failure to focus on the importance of market timing plants a suggestion in investors’ minds that the higher that one sets one’s stock allocation, the better. Buy-and-Holders often argue that investors don’t need to worry about price crashes because stock prices always come back after downturns. That’s true in one sense and false in another. Prices do always come back.
But it can take a long time for prices to come back after the huge drops that are experienced when prices reach very high CAPE levels and the investors who followed the reassuring advice miss out on the compounding returns that they would have enjoyed had they taken part of their money out of stocks when prices went crazy and reinvested it in stocks when prices returned to sane levels. The penalty attached to ignoring price when buying stocks can be heavy indeed.
Combining that mindset with the standard allocation advice can create a dangerous situation. Say that prices have reached a level where the proper stock allocation for most investors would be 30 percent. The standard advice already has most investors going with a stock allocation of two times the proper level.
In real life, the idea that many investors hold (and that is buttressed by the standard allocation advice calling for no allocation changes in response to price shifts) that stocks are always worth buying causes many investors to go with allocations in excess of two times what they should be.
It’s important to keep in mind that most investors are thrilled with their stock investments at times when prices are super high; it’s big price jumps that bring on high CAPE values. So investors are directing lots of mental energy to rationalizing ever higher stock allocations at such times.
Following Buy-And-Hold Principles
I knew many investors who swore fealty to Buy-and-Hold principles who went with stock allocations of a good bit higher than 60 percent at times when the CAPE value suggested a stock allocation of 30 percent.
Stock allocations of 80 percent were common. In fact, it became standard practice in Buy-and-Hold retirement studies purporting to reveal the safe withdrawal rate to use an 80 percent stock allocation as the default assumption. Huh?
It’s conventional wisdom that retirees should be going with lower stock allocations than younger investors. So what sense does it make for researchers who follow Buy-and-Hold principles in their work to assume 80 percent stock allocations for retirees?
You’ve heard of bracket creep – the progressive income tax structure causes people to pay a higher percentage of their income in taxes as their earnings increase. We could call the phenomenon that I am discussing here “stock allocation creep.” The standard 60 percent stock allocation is only a recommendation.
The investors most likely to pay attention to the recommendation are Buy-and-Holders, followers of a strategy that posits that stocks are always worth buying. The 60 percent allocation figure is viewed by many not as a target but as a floor.
The attitude is – one’s stock allocation should never drop below 60 percent but there is no particular problem if it goes above that level.
There was one popular poster at a discussion board at which I participated who went with a stock allocation of 89 percent. He claimed that this allocation level was “optimal.” He pointed to historical return data that did indeed indicate that this was so.
The flaw in his analysis was the flaw that plagues all research rooted in Buy-and-Hold principles; it did not adjust for valuations. There are of course times when a stock allocation of 89 percent is foolhardy.
It struck me as puzzling why an individual who was a strong advocate of the Buy-and-Hold Model for understanding how stock investing works essentially showed contempt for the standard asset allocation recommended by the most respected advocates of the strategy.
Variation In Stock Allocations
There were few others in that board community who felt as I did. The thinking seemed to be that the people who developed the standard asset allocation advice set the stock allocation number too low in deference to the “scaredy cats” who didn’t fully appreciate the wonders of stocks.
The true best stock allocation was the highest stock allocation that the investor could stand. Smart investors went with stock allocations of higher than 60 percent because stocks offer higher returns than other asset classes and stocks are never too risky for investors who have the stomach to stay the course.
Investors who timidly acknowledged going with stock allocations of less than 60 percent were at best tolerated and at worst mocked at board communities populated largely with Buy-and-Holders.
Investors who went with stock allocations of 80 percent or 90 percent or in a tiny number of cases even 100 percent were championed. Those were the investors with the intestinal fortitude it takes to retire early!
The suggestion that price doesn’t matter when buying stocks is a very dangerous suggestion. It plants thoughts in investors’ minds that can cause them to follow exceedingly dangerous strategies at the worst possible times for doing so.
Rob’s bio is here.
