Asset Allocation Actions

I want to set out some thoughts to what is probably the number one problem with investing - over allocation. 

Asset allocation is more art than science, but it should favour numbers specifically, valuation and volatility of the particular asset class.

Let’s use an example allocating $10,000 into a country ETF like Brazil. When it comes to the initial allocation, valuation should be the guiding principle. Obviously, the cheaper the market (via a valuation metric like CAPE) the higher the allocation. But here is the first mistake by rookie investors - allocating the whole $10,000 in the belief the investment wont fail or they won’t be scared out of it by higher or unexpected volatility. 

The solution is to always have an allocation of cash against the investment (so let’s start $7,000 in stock leaving $3,000 in cash) available should the price fall further. This allows future rebalancing if the price falls from your initial starting price and often when buying something that’s cheap, it will fall further since the market’s current view will most likely be unfavourable.

The second aspect is thinking about the volatility. We know with higher volatility assets, there is a need to rebalance more often allowing the investor to capture some profits before a fall and add to the position before a rise. If you are a long term investor, you can look at the historical volatility of the Brazilian ETF and decide to allocate the remaining $3,000 over the next 3 years with an additional $1,000 each year should the price continue to fall. 

Now to the second mistake of overallocation. Ignoring valuation and volatility or being too greedy. 

It’s never easy taking a profit mainly because after winning for a while, you believe there is “more to go”. And it is not helped by a finance industry which encourages investors to stay fully invested (in our mind, over-invested)  when markets are clearly expensive. It doesn’t mean you must sell everything but history shows it is always prudent to reduce market exposure when things get a little crazy - as in a CAPE of 38.

Let’s say our Brazilian ETF has risen from $7,000 to $12,000 in two years and the CAPE has gone from 10 to 23 (historical average of 15). Now if you say “Steve, the $10,000 would have made more profit”, then yes, but note here I am choosing one path of many potential paths. 

Here we should realise if we were starting out again, at this new CAPE of 23, our allocation should be something like $4,000 not $7,000. However, after a good win, investors will hesitate to sell  a large portion of the allocation because….well….it’s going to keep going up! Not so fast. History shows that the longer you hold an investment, the higher likelihood that returns decline over time to the long term average. So congratulations on buying cheap, but now we are in a different circumstance and you need to adjust the allocation accordingly. If we don’t rebalance we are over-allocated.

The solution is simple - reduce the allocation from $12,000 to $4,000, bank the profits and look for another undervalued asset.  Of course emotionally this is hard but logically it makes complete sense. 

To avoid over allocation, avoid emotions and choose valuation and volatility. You will be better for it in the long run.