Portfolio Allocation Shocker — Timing Beats Rebalancing!

Investors seeking guidance on how to set their portfolio allocation have been hearing for 25 years now that short-term timing does not work. It may be that for the next 25 years they will be hearing a seemingly contradictory bit of advice — that long-term timing does work.

Portfolio Allocation The contradiction is a surface one. The same historical stock-return data that shows that short-term timing (changing your portfolio allocation with hopes of receiving a benefit within one or two or three years) rarely works also shows that long-term timing (changing your portfolio allocation with hopes of receiving a benefit within 10 years and of seeing that benefit grow dramatically over 30 years) almost always works.

The reason is that investing is primarily an emotional endeavor in the short-term. Thus, short-term price changes are unpredictable and timing in anticipation of them is generally futile. In the long-term, however, the economic realities of stock investing come to dominate price changes. Thus, as your time horizon expands, your odds of making effective asset allocation changes in response to changes in valuation grow better and better and better.

The Investor’s Scenario Surfer, the third calculator developed by John Walter Russell and Rob Bennett to provide realistic guidance on the true message of the historical stock-return data, offers strong support for a shocking claim — rebalancing is not the way to go for a long-term investor seeking the optimal asset allocation. The better investing strategy is to go with a higher portfolio allocation when prices are low and a lower portfolio allocation when prices are high.

The Investor’s Scenario Surfer uses a random number generator to permit investors to test various portfolio allocation strategies without putting money at risk. The calculator tells the investor what annual return he would have received for each year of a hypothetical but realistic 30-year returns sequence, and permits him to make changes in his portfolio allocation at the beginning of each year. By comparing his results to the results that would have been obtained had he followed any of three rebalancing strategies, the investor can see with his own eyes the great benefits that generally follow from adoption of a valuation-informed asset allocation strategy.

Stock Portfolio Allocation Strategy A unique feature of the new calculator is that the random number generator contains two screens aimed at making the results obtained more true to the results likely to be obtained in real-world investing. Many investing calculators are built on the assumptions of the Efficient Market Theory, that the market price is a rational price and that there is no way for an investor to know in advance whether his long-term return on the stock portion of his portfolio allocation is likely to be better or worse than average. The Scenario Surfer rejects this assumption. Its results reflect more accurately the historical data itself, which shows that stocks provide far better long-term returns when purchased at reasonable prices (as common sense tells us they must).

Thus, the Sample Results that appear above show that following a practice of lowering the stock portion of your total portfolio allocation when prices go to extremely high levels pays off big time in the long run. Stocks are often the best investment class for the long run, just as the famous book title asserts. However, there are exceptions, according to the asset allocation calculator. When the P/E10 (the valuation assessment tool used in all three investing calculators developed by Russell and Bennett) level goes above 20 (the number was 29 in October 2007, when this article was posted), it is generally a good idea to reduce the percentage of stocks in one’s portfolio allocation to 30 percent or less.

To run your own scenarios with the Scenario Surfer, please click on the “Clear All Entries” button at the top of the page. Then choose a portfolio amount and a Treasury Inflation-Protected Securities (TIPS) return amount (portfolio allocation amounts not held in stocks will be assumed to be earning the rate of return you specify as the TIPS return). Next choose a P/E10 value for the beginning of the 30-year investing scenario that will be examined (you may want to experiment with valuation levels other than that which applies today to gain a sense for how much more fun stock investing will become again once prices return to more reasonable levels). Finally, enter stock allocation percentages on a year-by-year basis as the Surfer reports your results for the earlier year and indicates the updated P/E10 value to be used in selecting your portfolio allocation for the new year.

Portfolio Allocation CalculatorThe Sample Results show a case in which following a valuation-informed portfolio allocation strategy caused a portfolio valued at $100,000 to grow to a value of $624,156 (these numbers are inflation-adjusted, so the growth shown here is real growth) at the end of 30 years. The Scenario Surfer shows that the same returns sequence would have generated a final portfolio value of $401,052 for an investor following an 80-percent-rebalancing portfolio allocation strategy. Someone following a 50-percent-rebalancing asset-allocation strategy would have obtained a final portfolio value of $338,817. And someone following a 20-percent-rebalancing asset-allocation strategy would have obtained a final portfolio value of $261,889.

The Sample Results show the results of only a single returns sequence. There are of course an unlimited number of possible scenarios. So you need to run the Scenario Surfer numerous times to gain a full sense of the power of valuation-informed portfolio allocation strategies. What you will find is that long-term timing consistently beats rebalancing. In some cases the benefit of paying attention to valuations will be greater than what is suggested by the Sample Results and in some cases the benefit will be not as great. In rare cases rebalancing will provide a better 30-year return. The calculator shows clearly, however, that the odds are with the investor following valuation-informed portfolio allocation strategies.

John Walter Russell is the owner of the Early-Retirement-Planning-Insights.com web site, at which he provides over 500 articles reporting on his original and groundbreaking research into the true message of the historical stock-return data. Russell’s research is the engine of the new calculator.

Rob Bennett is the owner of the PassionSaving.com site and the author of Passion Saving: The Path to Plentiful Free Time and Soul-Satisfying Work. Rob is the leading voice of the New School of Safe Withdrawal Rate (SWR) Analysis, a school that seeks corrections in the Old School SWR studies, studies likely to cause millions of busted retirements in days to come in the event that stocks perform in the future anything at all as they always have in the past.

The article “Valuation Ratios and the Long-Run Stock Market Outlook: An Update,” by John Y. Campbell and Robert J. Shiller, provides background on the P/E10 tool, the tool that makes this portfolio allocation calculator unique. The P/E10 tool captures the reality ignored in much of today’s “expert” investing advice, that the valuation level at which an index fund purchase is made has a large bearing on the long-term results obtained from it. All of the stock returns reported by the calculator assume a purchase of the S&P index and all assume that stocks will perform in the future at least somewhat as they always have in the past.

Asset Allocation Strategies P/E10 fell to between 5 and 6 in 1921 and 1932, and to between 6 and 7 in 1922 and 1982 (the starting-point of the huge bull market). The highest recorded P/E10 value is 44 (reached in early 2000, perhaps the ending point of the huge bull market). A moderate P/E10 value is 14. P/E10 exceeded 24 in 1928, 1929, 1930, 1966, and in all the years from 1995 through late 2007 (when this article was posted). Low P/E10 values translate into high long-term returns. High P/E10 values (20 or above) translate into low long-term returns.

The Investor’s Scenario Surfer is intended to serve as a guide to how changes in stock valuation may affect asset allocation strategies. Please understand that the calculator developers are learning right along with the users of the new tool. Please check what you learn from the calculator against the information provided by other sources and know that many big-name experts take issue with the idea that valuations affect stock returns or that they do so in a predictable way. The portfolio allocation calculator is a learning tool. Please do learn from it, but please also strive to take a skeptical attitude toward all investing advice, including that supported by the findings of the Investor’s Scenario Surfer.