Part 5 of this series implies a scary conclusion: investors as a group, and buy-and-hold investors in particular, will tend to have their highest percentage allocation to equities when the equity market is topping out and their lowest allocations to equities when the equity market is bottoming out.
Let’s take a look at four primary types of asset allocation approaches in the context of equity market levels:
Some investors not only allow their equity allocations to grow with rising stock prices, they actually sell bonds and buy equities when they observe that stocks have been doing well, and they bail out of stocks when stocks have been doing poorly. These investors “jump on the bandwagon” when performance has been superior for a few years and sell off their equities at the bottom of a bear market. They are trend followers who respond to extreme trends. They tend to succumb to their greed when equities are relatively high and to their fear when equities have collapsed.
Some investors “set it and forget it” when it comes to asset allocations (as long as their financial situation has not changed). These investors are in the center of the group because, as a group, all investors on average have equity allocations that rise and fall with the equity market.
Some investors regularly rebalance their portfolio to long-term allocation targets. The frequency of this rebalancing activity matters. When investors rebalance over time horizons that match time intervals corresponding to price reversion, the rebalancing activity can be return-enhancing. However, rebalancing during trends can lower returns.
Some investors try to detect market extremes in the hopes of correctly timing when a strong trend has reached its end and prices are destined to begin price-reverting. These individuals buy when other investors see no hope, and sell when other investors see no downside.
At this point it may appear that the discussion is leading to an admonishment to avoid “climbing on the bandwagon” and to encourage being a steady rebalancer, or perhaps even a contrarian. But that advice is contraindicated by long term evidence that indicates that markets – equity markets in particular – are well described over reasonably long time horizons as being trending. So, the solution remains unclear.
So what should a rational, somewhat conservative investor who does not want to try “jumping on the bandwagon” or try being a contrarian do? The last part of this series provides some ideas.