Real Dynamic Asset Allocation

While there has been a great deal of talk about the root causes of the housing debacle and how to avoid the repeats of such bubbles, regulatory fixes, etc., there has been a very little, if at all, a talk of investor's exposure to the equity asset class. A small minority of investors had little or no exposure to the equity asset class, however, most had a meaningful exposure to this risky asset class (with higher potential rewards) and they inadvertently took a big bath in last year's panic driven market meltdown.

According to a conventional school of thought, investor's asset base is divided between various asset classes such as stocks, bonds, cash, etc. depending on one's age and risk tolerance. More sophisticated asset allocation will utilize other asset classes such as real estate, commodities and hedge funds. More often than not, emphasis is not given at all to equity class valuations. That is where the dynamic asset allocation can come into play.

It has been real unfortunate that countless retirees or working population on the verge of retiring have had heavy exposure to the equity asset class in 2008 only to see almost one half of it to evaporate overnight. One cannot predict highly unlikely events like this with an uncanny ability or any consistency. Yes, housing bubble was witnessed by many and they predicted that it was destined to be popped some day. Yes, equity valuations were also quite reasonable or so we were told by all the equity strategists as they were hovering near or approaching their multi-decade average. Nevertheless, extremely small minority even predicted the equity class debacle that ensued following the housing bubble busting. What is one gotta do under such circumstances?

The only real solution I see is either to use the equity class quite sparingly or have a real dynamic asset allocation. There is no other way around it, if someone were to sidestep such catastrophes. The bottom line is it really is not worth it to have it otherwise. If you were to scale down equity exposure meaningfully, then, yes, the portfolio may not gain as it may otherwise, however, at the same time, you may be spared a pain of a lifetime as several families are witnessing at this moment. So, in other words, is that extra three to four percentage points in returns, at best, really worth it to have an outsized exposure to equities? To me, the answer is NO for the great majority of investors. Alternatively speaking, as some investment advisors exclusively focus on, wealth preservation is the key and not the asset growth.

Yes, most investment advisors do the asset allocation which is dynamic in the sense that the percentage of equity allocation among all other asset classes is determined based on the age and risk tolerance. Further more, there is an annual rebalancing done within the portfolio amongst various asset classes based on the set percentages or investment criterion.

However, the "real dynamic" asset allocation as I would like to call it is to add one more criterion to the allocation criterions. And that is the "Valuation" criterion. For example, a regular dynamic asset allocation may say that the investor at the age of 50, should have 50% exposure to the equities. However, there is no consideration or an emphasis given to the equity valuations at all. So, how about using a criterion such as at price to earnings (PE) ratio of 10 or less, one should have a full exposure at 50% (predetermined maximum level), however, rise in PE by each additional point will scale back equities exposure by 5%. That means, if the PE ratio is at 15, equity exposure is only 25% and when the PE ratio is at 20, one is completely out of equities.

This would have spared an investor tremendous amount of grief during the collapse of dotcom bubble as well as 2008 financial markets meltdown. No doubt one needs to stick to more consistent and uniform method to measure the PE ratio of an index such as S&P 500 or Wilshire 5000 Total Market Index . This type of risk management and "real dynamic" asset allocation adds a great deal of value to a conventional asset allocation.

Alternatively, one can always have an outsized exposure to the fixed income with only a minimal exposure to the equities on a permanent basis. As I mentioned earlier, is it really worth it to sacrifice life's worth of savings for few extra percentage points in return during those rare events? Is any meaningful exposure to even seemingly rare events really worth it?