Part 7: Market Timing and Putting it all Together
Part 6 discussed four common types of investors whose strategies varied from betting on price trending, to betting on price reverting. This part tries to develop conclusions regarding these complex issues and which strategies might be appropriate.
First, asset allocation is not simply about selecting a percentage of the portfolio to place in equities. It is about deciding between equities, bonds, alternative investments, cash, and personal investment opportunities such as college educations, personal real estate, life insurance policies and so forth. Further, each decision regarding an asset class like equities involves numerous other decisions. For example, equity allocations can be further allocated into subclasses such as domestic vs. international, growth vs. value, and so forth.
Still further, a key issue touched upon in Part 1 is that whether markets trend or revert may change through time and clearly depends on the time horizon. I believe there are different tendencies towards trending over different time intervals such as quarterly, annually, and longer.
All of which lead to the following three suggestions:
1. Asset allocation should be primarily driven by financial circumstances, sophistication, experience, goals, and risk tolerance. Therefore, an investor’s equity allocation should be based on taking a suitable level of risk. Large changes to that allocation should be driven primarily by large changes in the investor’s circumstances and preferences, not in attempts to time markets. Market timing should generally not be used to make major long-term changes to allocations.
2. Equity markets have demonstrated a tendency to trend over time periods of many months to perhaps a few years. Nevertheless, an investor’s overall risk and asset allocation (particularly the exposure to equity market risk) should be rebalanced periodically to keep risk levels within tolerable bands even though rebalancing increases the chances of missing some gains from upward trends and of investing additional funds during downward trends. A portfolio with a targeted 60% allocation to equities should be considered for rebalancing if the actual allocation exceeds perhaps 65% or falls under 55%.
3. Most securities markets have demonstrated a tendency to revert over periods of several to many years when the asset class has experienced dramatic gains or losses. Investors may wish to consider strategies of modest reductions in target allocations for asset classes or sub-classes that have overperformed very substantially in the last 2-5 years, and modest increases in target allocations to those that have underperformed very substantially in the last 2-5 years.
In all cases, temperance should prevail. Focus should never be allowed to stray too far from the general objective of keeping overall portfolio risk within a range that is appropriate for the investor in light of circumstances and preferences.