On Asset Allocation

Sam Ngooi Comments

This month we present an expanded discussion on asset allocation, which we think is pertinent in light of the major gains in US stock prices for the year 2019. Using the S&P 500 as a proxy for US stocks, the index advanced from 2,507 at year-end 2018 to 3,231 at year-end 2019, a 724 point, or 28.9%, increase. (Unless otherwise noted, the quoted passages below come from a Jeff Sommer article titled Forget the Less Than Worthless Stock Market Forecasts (NYT, 12/29/15, page B5).)

Asset allocation, a fundamental principle used by Park Piedmont Advisors (PPA) in the management of client portfolios, refers to the percentage mix of the four major asset classes –Stocks, High-Yield Income, Bonds and Cash Equivalents– in our clients’ liquid investment portfolios. (Note: we split high-yield income (HYI) off from high-credit bonds (HCB) based on their very different investment characteristics, as exemplified during the 2008-9 financial crisis.)  Appropriate asset allocations consider each client’s specific financial objectives, and that client’s risk tolerance in reaching those objectives. Once clients have accumulated enough money to carry out their objectives, PPA regularly advises that stock allocations be reduced, as stocks are the riskiest part of the overall allocation.  (We define risk as the likelihood of significant declines in portfolio values that would jeopardize our clients’ ability to meet their objectives.) Once an allocation has been agreed upon, PPA monitors over time to determine whether it is still appropriate for each client’s circumstances, in case of a significant change in personal circumstances and/or a major change in the value of one asset class compared to the others.

When one asset class does deviate from a specific allocation, either because of relative over- or under-performance compared to the other asset classes, rebalancing to return to the original allocation may be in order. To illustrate the idea: assume a $1 million portfolio with an allocation of 40% stocks and 60% bonds at the start of 2019. By year-end 2019, the stock portion would have increased from $400,000 to $515,600. The bond portion (using high credit, intermediate-term taxable bonds as a proxy), which also had an excellent year, increasing approximately 9% (prices plus interest), would have a value of $654,000. The total year-end 2019 value would be $1,170,000, and the percentage mix would be 44% for stocks and 56% for bonds. This 4% of change (higher for stocks and lower for bonds) could merit a conversation about returning to the original 40-60 mix, by selling the higher performing asset class (stocks) and buying the lower performing asset class (bonds).

It is important to note that in 2019 both stock and bond markets had excellent years compared to their historic average annual returns, so any rebalancing done in this time frame would be at very high prices for both asset classes.  Further, since a major factor in rising bond prices is declining interest rates, and declining interest rates have been cited as a reason for investors to turn to more aggressive investments to achieve a suitable investment return, there is caution in all parts of the financial markets. “When (interest) rates on safe securities go negative (as in parts of the international developed world) — or ultra-low, as they are in the US, investors feel compelled to take on greater risk to get what they consider an acceptable return on their money” (Bloomberg Business Week 12/23/19, page 9).

A few other important points to note:

  • PPA uses broad-based, low-cost index mutual funds and exchange traded funds (ETFs) to implement our clients’ asset allocations, so the portfolio investment results should closely approximate the actual index results.
  • Rebalancing may involve sales with capital gains tax consequences in taxable, non-retirement accounts. We take these potential consequences into account when making portfolio change suggestions.
  • Rebalancing is not market timing. Market timing, which PPA does not engage in, describes investors who make predictions about the future direction of markets, and then execute transactions designed to profit from those predictions. We consider this extremely difficult, if not impossible, to do with any consistency over the long-term. By contrast, rebalancing involves returning to a prior asset allocation when certain criteria are met, without reference to any future market predictions.
  • For more on the futility of market timing, Sommer writes: “It is the time of year for predictions, and I will make one. You will be better off ignoring the Wall Street stock market predictions for 2020.… Many Wall Street strategists are flagrantly inaccurate…. It is true they are right about the market’s direction more often than they are wrong. But that’s only because most of them say the market will rise in the next year, which happens about 70% of the time. The more specific forecasts – like how high or low the market will go in a given year, and whether it will lose half its value or rise 30% – should be treated as fiction… There is a more reliable and simpler way to make investing decisions, one that doesn’t rely on putative forecasts. It is based instead on long term historical data on the stock and bond markets. They show that stocks outperform bonds over extended periods, but that stocks are far more volatile than bonds. Holding both stocks and bonds makes sense because they tend to buffer one another. Investing over the long run through low cost index funds in a broadly diversified portfolio is a reasonable approach for most people.”
  • Sommer’s article cites Jack Bogle, the founder of Vanguard, and David Booth, co-founder of Dimensional Fund Advisors (DFA, about which we have been writing recently now that PPA has access to the DFA funds). Booth is quoted as follows: “We don’t try and forecast the future. We have no ability to do it. Nor does anyone else…. Forget the forecast and for purposes of investing forget about the current news too…. Take on only as much risk as you can handle. Find a stock-bond mix that you are comfortable with and then stick with it…. One way of thinking about risk is to imagine a terrible downturn is about to occur…” Then, consider how much percentage decline your portfolio will incur based on the market’s percentage downturn (e.g., a 30% stock market decline for a portfolio allocated 30% to stocks results in a 9% decline). Asset allocation can therefore play an important role in managing the risk inherent in all investments.