Do you adjust your AA based on valuations?

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Do you adjust your Asset Allocation based on valuations?

Yes, written into my IPS
22
20%
Yes, based on what feels right at the time
22
20%
No, don't believe it increases odds of goal acheivement
40
37%
No, too complicated for me
24
22%
 
Total votes : 108

Re: Do you adjust your AA based on valuations?

Postby Scooter57 » Mon May 13, 2013 5:32 pm

Lazyday,

The tool I've used to value individual stocks is F.A.S.T Graphs, from Chuck Carnivale who posts frequently on Seeking Alpha. It uses the approach of Benjamin Graham in a very understandable way. I checked out all the Dividend Champions with it, stocks that have raised their dividend every year for decades, and found almost all of them bid up to where they were far from being bargains, except for a few that are facing severe declines in revenue. This was in Feb. All have gone up quite a bit since then, reducing the dividend yield.

There are several I'd like to purchase if we get a correction (my investment plan allows me a small percent of individual stock purchases) but I wouldn't touch them at today's valuations.

F.A.S.T. Graphs can be tried for free for 2 weeks. It's very educational to look at various stocks through its valuation lens. I looked at the top holdings of funds I was considering to get a feel for where the market was at in terms of classic valuations. I paid for it for another 2 months ($9.99/month). When we get another correction I will subscribe again to help me understand how companies are faring.

N. B. The valuations won't predict stock prices in the short term. They do give you a feel for whether a company is earning enough to justify its current price and support its dividend. Of course, you have to look more deeply into a company to determine what the earnings numbers might really mean, but they are a good starting point.
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Re: Do you adjust your AA based on valuations?

Postby abuss368 » Mon May 13, 2013 10:50 pm

Not at all. Everything follows our asset allocation.
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Re: Do you adjust your AA based on valuations?

Postby Random Musings » Mon May 13, 2013 10:58 pm

lazyday wrote:
I agree with Larry on most things but not dividends for some retirees who put in the effort, and have a sensible strategy.


Well, I can't argue that some retirees will do well with the dividend strategy who put in effort and have a strategy which seems sensible. But most will still underperform, it's a probability game. I think that one also has to remember that comparing a dividend strategy to a cap weighted blend index like the S&P is not quite comparing apples to apples. Yes, returns are higher but there are other asset classes that even have higher returns in the long run - like value.

I think all active investors have to take into consideration what the markets are asking every day - as Dirty Harry once said, "you've got to ask yourself one question: Do I feel lucky? Well, do ya, punk?

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Re: Do you adjust your AA based on valuations?

Postby lazyday » Tue May 14, 2013 3:22 am

Scooter57 wrote:I checked out all the Dividend Champions with it,

Thanks for the explanation.

I didn’t realize how popular dividend growth is. When I hear “dividend stocks” I think “higher than avg yield” but perhaps lately it has come to mean dividend growth instead.

Larry’s post was on SDY, which is a Dividend Achievers index, also dividend growth. So it seems you have proven his point, or vice versa. Some of the stocks in SDY are ones I’ve sold because of valuations.
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Re: Do you adjust your AA based on valuations?

Postby lazyday » Tue May 14, 2013 3:34 am

Random Musings wrote:I can't argue that some retirees will do well with the dividend strategy who put in effort and have a strategy which seems sensible. But most will still underperform, it's a probability game.[snip]

By “some retirees” I don’t mean the some who succeed, but the some for who the risk-reward profile of their specific type of dividend investing is appropriate. It may not be about performance, but survivability.

If investing for retirement, dividend investing probably makes no sense. Larry and others have covered the downsides.

If investing in retirement, you need to pay your bills. If you have a generous pension, or can afford to hold lots of fixed income, then a dividend strategy is not needed.

In the event of an extended deep downturn, withdrawing from principle could be dangerous. If stocks fall 90% or more, I do not want to depend on selling stock indexes to pay my bills. Even a more shallow downturn could ruin me.
I feel more safe with my strategy, which does not depend on very high yield, nor on dividend growth. My stocks probably don’t have much of a value loading. But I think most could keep paying much of their dividends in a terrible economy and market. I have made compromises, including concentration risk. This has lately become severe in sector: health care. I am attempting to find acceptable companies in other sectors.
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Re: Do you adjust your AA based on valuations?

Postby LH » Tue May 14, 2013 4:41 am

Sammy_M wrote:Based on discussions here and the writings of folks like Wade Pfau, I have at times considered amending my IPS to call for a downward shift in equities as P/E10 levels exceed normal ranges. With mean P/E10 around 16, the current 24 level seems like a time to start downshifting.

Do you adjust your stock/bond allocation based on P/E10, Tobin's q, or some other valuation metric? Why or why not?



I downward adjust my stock bond ratio behaviorally using my gut.

I basically use two inputs

Current market valuation
My current net worth in relation to my life cycle earning.

The market is "up" now, I am 43, have an ok net worth, and so have dropped from 84 stock 16 bonds
To 81 stock 16 bonds 3 gold --- expecting gold to drop near term.
Then today
Went to
78 stock 19 bonds 3 gold.

These are one way changes. I am dialing down my risk as I age, but not using an age rule, just behaviorally winging it, and trying to not buy high, like when he market tanks, I won't go to bonds and sell stocks low then. Gold I waited a year, hasn't dropped as much as I thought.

Really I may dial back stocks more, get more bonds, but I am running into having to sell taxable assets to do it.

Trying to figure out where I am in my life cycle, may dial back work some, save less. If so, then what I have now saved is more important, as less accumulation going forward, means less dca, buying low if stocks tank for years.

It's complex. Savings rate. Earning potential. Net worth. All Can vary current/ future. Age marches on inexorably and predictably while one lives. But age is a weak proxy really.

Cheers,

LH
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Re: Do you adjust your AA based on valuations?

Postby letsgobobby » Tue May 14, 2013 11:19 am

That's a good point - would I keep rebalancing and/or following a valuation-based AA if it meant selling stocks in taxable and generating capital gains to do so? Assume all tax-deferred space is bonds, all new money goes to bonds, and all taxable dividends/capital gains are not reinvested... I'm not there yet, so don't have to answer, yet.
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Re: Do you adjust your AA based on valuations?

Postby Rodc » Tue May 14, 2013 11:38 am

So far no.

1) you can't look at stocks in isolation, you must think about the portfolio as a whole. If stocks stink (high valuation) and other assets are even more over priced (say bonds have negative real yield) should you really be selling stocks to buy bonds? All stock valuation trading studies I have ever seen, including some I have done, suffer this serious flaw.

2) rebalancing helps a little, but frankly you tend to be buying and selling so little so infrequently that most of the time it has little effect. The rare occasion when the markets go crazy it is useful. Say when markets really crash, then rebound. (no guarantee of a nice rebound though).

3) minor shifts due to changing valuations will not have a significant impact, good or bad. You have to make big bold moves to get a big bold impact. I don't think the risk return trade off from big bold moves is generally favorable. IMHO, not worth the bother to make small timid moves, so I just keep on keeping on ignoring valuations.

4) as I near retirement (say 6-10 years off), if the market soars or crashes in a dramatic fashion I might find myself in a rather different situation than I had planned, where the risk reward trade off changes far from expected, I could imagine a one time variance from my current practice. For example if we have the stock market soaring to P/E10 of 44, I might very well take more off the table than simply rebalancing. But maybe not.
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Re: Do you adjust your AA based on valuations?

Postby grayfox » Tue May 14, 2013 11:41 am

It is easy to see why returns are not correlated to valuations over the short term, but determined by valuations in the long term

Consider the annual returns of the Vanguard Total Stock Market Index Fund (VTSMX). The Total Return consists of the Capital Return, which is price changes, and Income Return which is dividends.

Code: Select all
Year  Capital Return Income Return  Total Return    Cap/Inc Ratio
2012       13.90%       2.35%       16.25%           5.9
2011      –0.86%        1.82%        0.96%           0.5
2010       14.97%       2.12%       17.09%           7.1
2009       25.92%       2.78%       28.70%           9.3
2008      –38.35%       1.31%      –37.04%         -29.3
2007       3.73%        1.76%        5.49%           2.1
2006       13.63%       1.88%       15.51%           7.3
2005       4.28%        1.71%        5.98%           2.5
2004       10.70%       1.82%       12.52%           5.9
2003       29.50%       1.86%       31.35%          15.9
2002      –22.03%       1.07%      –20.96%         -20.6
2001      –12.03%       1.06%      –10.97%         -11.3
2000      –11.52%       0.94%      –10.57%         -12.3
1999       22.44%       1.37%       23.81%          16.4
1998       21.69%       1.57%       23.26%          13.8


Higher valuations, mean lower earnings yield and dividend yield, so the Income Return gets smaller. Valuations matter for income return.

But in any year, the Capital Return swamps the Income Return. I calculated that, on average, capital return is 10x income return. So in the short term, the total return is dominated by price changes. Therefore valuation has little effect in the short term.

But much of the price movements from year to year cancel out. Look at the big negatives that wipe out much of the big positives. Over the long term capital return becomes less dominant.

:arrow: Valuation does not matter in the short term, but it does in the long term.
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Re: Do you adjust your AA based on valuations?

Postby Rodc » Tue May 14, 2013 11:47 am

Valuation does not matter in the short term, but it does in the long term.


But matters in what way?

1) It matters in your long term returns (or expectations, planning) going forward?

2) Or matters as far as what trading strategy one should use? That is, it allows you to employ some sort of allocation switching or tactical asset allocation strategy to improve portfolio performance (risk and/or return).

Seems to me it matters in case 1, not so much in case 2. If I understand the OP, case 2 was the question.
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Re: Do you adjust your AA based on valuations?

Postby Random Musings » Tue May 14, 2013 11:52 am

[quote="lazyday]
In the event of an extended deep downturn, withdrawing from principle could be dangerous. If stocks fall 90% or more, I do not want to depend on selling stock indexes to pay my bills. Even a more shallow downturn could ruin me.
I feel more safe with my strategy, which does not depend on very high yield, nor on dividend growth. My stocks probably don’t have much of a value loading. But I think most could keep paying much of their dividends in a terrible economy and market. I have made compromises, including concentration risk. This has lately become severe in sector: health care. I am attempting to find acceptable companies in other sectors.[/quote]

If stocks would fall 90%, dividends would fall. I guess your bet in health care does ride on the idea that dividends would fall less, and maybe price. History does suggest that healthcare tends to be less volatile on the downside. However, concentration in that sector does bring up specific regulatory risk.

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Re: Do you adjust your AA based on valuations?

Postby grayfox » Tue May 14, 2013 12:00 pm

Rodc wrote:
Valuation does not matter in the short term, but it does in the long term.


But matters in what way?

1) It matters in your long term returns (or expectations, planning) going forward?

2) Or matters as far as what trading strategy one should use? That is, it allows you to employ some sort of allocation switching or tactical asset allocation strategy to improve portfolio performance (risk and/or return).

Seems to me it matters in case 1, not so much in case 2. If I understand the OP, case 2 was the question.


Valuation matters in terms of what return you should expect over the long term for an investment made today.

The mistake that people make is thinking that because valuations are above some historical average, which they'll call "over-valued", it means that they will correct to "fairly-valued".

IMO, there is no "over-valued or "undervalued". Stocks have some expected future earnings and dividends, and the price you pay will determine the return you can expect from that future cash-flow. The higher the price, the lower the expected return.
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Re: Do you adjust your AA based on valuations?

Postby Sammy_M » Tue May 14, 2013 12:47 pm

Rodc wrote:
Valuation does not matter in the short term, but it does in the long term.


But matters in what way?

1) It matters in your long term returns (or expectations, planning) going forward?

2) Or matters as far as what trading strategy one should use? That is, it allows you to employ some sort of allocation switching or tactical asset allocation strategy to improve portfolio performance (risk and/or return).

Seems to me it matters in case 1, not so much in case 2. If I understand the OP, case 2 was the question.

That is correct. I treat case 1 as a given. In posing this question, I was referring to case 2. Thanks for the discussion. I find it very interesting.

Rodc wrote:3) minor shifts due to changing valuations will not have a significant impact, good or bad. You have to make big bold moves to get a big bold impact. I don't think the risk return trade off from big bold moves is generally favorable. IMHO, not worth the bother to make small timid moves, so I just keep on keeping on ignoring valuations.

The trouble that I have, and I expect others may as well, is that bold moves are psychologically hard to make. If my IPS states that I must adjust 3% out of stocks for each 1pt move in P/E10 above 23 (or add 3% for each move below 11), I can stomach those smaller changes.

grayfox wrote:IMO, there is no "over-valued or "undervalued". Stocks have some expected future earnings and dividends, and the price you pay will determine the return you can expect from that future cash-flow. The higher the price, the lower the expected return.

I suppose one could say that the markets establish value at any given point in time, and there is no "over" or "under" to it. However, when the market price delivers less compensation for bearing equity risk (comparing E10/P to long-term TIPS yields), is it not rational to take on less equity risk?
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Re: Do you adjust your AA based on valuations?

Postby Rodc » Tue May 14, 2013 2:49 pm

The trouble that I have, and I expect others may as well, is that bold moves are psychologically hard to make. If my IPS states that I must adjust 3% out of stocks for each 1pt move in P/E10 above 23 (or add 3% for each move below 11), I can stomach those smaller changes.


The challenge is that 3% is almost noise. I don't even rebalance on 3% moves. And it is entirely unclear it helps. For example right now you'd be selling "over priced" (maybe) stocks to buy over priced bonds. Even "over priced" stocks can and generally do continue to rise (momentum). When and if bond yields rise, you could lose on the bonds on top of losing out on stock momentum. Until of course things crash in which case if you have only moved 3%, 6%, 9% you will still take a big hit (move from 60% stocks to 50%, market drops 50% you get a benefit of 5%, but you could just as easily start 5% lower do to missing out on the run up to the crash.) I would also point out that historically, prior to 2008, you would make your move to buy when P/E10 hit single digits. Only in 2008-2009 P/E10 never got to single digits (I do think you'd have had chance for one 3% if your trigger was 11, but you would then have been underweight as the market more than doubled!)

I have looked extensively at this using P/E10 and Tobin's q. It is not a crazy idea. Done in moderation it is not all that dangerous. Nor all that helpful. Near as I can tell. Now of course to be fully honest I do a little valuation timing if you will: new money goes into assets that are below target, which tends to put money into bonds when stocks are riding high, and into stocks when stocks are riding low. In extreme cases new money is not enough and I sell bonds to buy stocks or the reverse. But if I am not going bold, and I'm not, my general position is I might as well stop there.

So that is how I come to my position. Others will differ of course.
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Re: Do you adjust your AA based on valuations?

Postby grayfox » Tue May 14, 2013 6:09 pm

Sammy_M wrote:
grayfox wrote:IMO, there is no "over-valued or "undervalued". Stocks have some expected future earnings and dividends, and the price you pay will determine the return you can expect from that future cash-flow. The higher the price, the lower the expected return.

I suppose one could say that the markets establish value at any given point in time, and there is no "over" or "under" to it. However, when the market price delivers less compensation for bearing equity risk (comparing E10/P to long-term TIPS yields), is it not rational to take on less equity risk?


I think you one should take expected return into consideration when making a new investment. However, not by adjusting your overall asset allocation based on valuation. Here is an example.

Suppose I save $1000 every month to invest for retirement, which is in 30 years. I think that certainly qualifies as the long term. Let's say I've decided that I require a 2% real return to meet my goals, and I'd like to do this with the least risk. To simplify, assume there are only two assets 30-year TIPS and S&P500 Index fund.

So where should I put my $1000 this month?

I look at 2043 TIPS and see it has YTM of 0.715%. Well that's not going to work by itself.
The I look at S&P500. Average real earnings for past ten years, E10, was $67.
Trailing 12-months dividend is $32.25.
The price for S&P500 is currently $1650, so earnings yield is 4.08% and dividend yield is 1.95%
I also expect both earnings and dividends to grow at some annualized rate over the next 30 years.

Let's say that I decide my best guess at expected return for S&P 500 over next 30 years is 4% above inflation.
Of course there are errors bars maybe +/- 4%, in other words maybe the range of outcome (95% confidence interval) is 0% to 8% p.a.

So to get 2% expected real return, I can have 61%/39% S&P500/30-YR TIPS

A couple of years ago, when TIPS were yielding 2%, the solution would have been 0/100. In other words, you could have put the whole $1000 into a LT TIPS and met your 2% goal with no risk. Today you have to take a lot of stock risk to meet your goal. :mad:

Note that S&P 500 valuations are higher now than 2 years ago, but you now have to put a greater amount into S&P500 because the safe asset is paying less.
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Re: Do you adjust your AA based on valuations?

Postby Rodc » Wed May 15, 2013 6:57 am

grayfox wrote:
Sammy_M wrote:
grayfox wrote:IMO, there is no "over-valued or "undervalued". Stocks have some expected future earnings and dividends, and the price you pay will determine the return you can expect from that future cash-flow. The higher the price, the lower the expected return.

I suppose one could say that the markets establish value at any given point in time, and there is no "over" or "under" to it. However, when the market price delivers less compensation for bearing equity risk (comparing E10/P to long-term TIPS yields), is it not rational to take on less equity risk?


I think you one should take expected return into consideration when making a new investment. However, not by adjusting your overall asset allocation based on valuation. Here is an example.

Suppose I save $1000 every month to invest for retirement, which is in 30 years. I think that certainly qualifies as the long term. Let's say I've decided that I require a 2% real return to meet my goals, and I'd like to do this with the least risk. To simplify, assume there are only two assets 30-year TIPS and S&P500 Index fund.

So where should I put my $1000 this month?

I look at 2043 TIPS and see it has YTM of 0.715%. Well that's not going to work by itself.
The I look at S&P500. Average real earnings for past ten years, E10, was $67.
Trailing 12-months dividend is $32.25.
The price for S&P500 is currently $1650, so earnings yield is 4.08% and dividend yield is 1.95%
I also expect both earnings and dividends to grow at some annualized rate over the next 30 years.

Let's say that I decide my best guess at expected return for S&P 500 over next 30 years is 4% above inflation.
Of course there are errors bars maybe +/- 4%, in other words maybe the range of outcome (95% confidence interval) is 0% to 8% p.a.

So to get 2% expected real return, I can have 61%/39% S&P500/30-YR TIPS

A couple of years ago, when TIPS were yielding 2%, the solution would have been 0/100. In other words, you could have put the whole $1000 into a LT TIPS and met your 2% goal with no risk. Today you have to take a lot of stock risk to meet your goal. :mad:

Note that S&P 500 valuations are higher now than 2 years ago, but you now have to put a greater amount into S&P500 because the safe asset is paying less.


I confess that seems a little like the tail wagging the dog to me.

Any estimates of stock returns and risk going forward are so likely to be hugely wrong for one thing that this approach seems more wishful thinking than actual sound planning.

Setting that aside, suppose you can do a decent job of estimating returns/risk going forward. Putting less in stocks when you think they will return more seems totally backwards. You should put more in when you think returns will be high so that when later returns are expected to be low that is ok: by putting more in when returns are high you can still get to your target in spite of bad times. The goal is certainly not to try to get 2% per year every year. That will never happen, not even close. The goal is to get an average of 2%. This is more likely if you buy more stocks when returns are expected to be high than buying more when returns are expected to be low. I think the risk of getting well below 2% is going to be higher if you try to hit 2% per year by cutting off the good times.

In the end though, given just how fickle stock market returns are, and despite a number of well known posters who feel you have to make predictions to make buying decisions, I think it is a fools errand. This is almost setting up a plan where you buy based on a random number generator.

One should focus on what is under your control. Set some more or less reasonable asset allocation between stocks and bonds (split those up if you wish into subasset classes) based on a broad long term view of the market, if long term prospects look poor save more than otherwise or lower expectations. If long term prospects look good, ignore, do not reduce savings because it is so easy to be wrong, and don't get caught up in day dreaming about all the money you are going to make as it is so easy to be wrong.
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Re: Do you adjust your AA based on valuations?

Postby grayfox » Thu May 16, 2013 9:47 am

Rodc wrote:I confess that seems a little like the tail wagging the dog to me.

Any estimates of stock returns and risk going forward are so likely to be hugely wrong for one thing that this approach seems more wishful thinking than actual sound planning.



One thing you are missing is that, while there is great uncertainty in what a stock investment will return, there is little to no uncertainty in what a TIPS bond investment will return. When 30-year TIPS are yielding 0.7% real, that is pretty much what you are gong to get. Another way of saying that is, there is almost a perfect forecast for TIPS returns.

So if you have a fixed 50/50 TIPS/stock allocation no matter what interest rates are, then half the portfolio is virtually guaranteed to not meet you goal. It doesn't make sense to continue buying them in the same proportion regardless of interest rates.
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Re: Do you adjust your AA based on valuations?

Postby grayfox » Thu May 16, 2013 9:55 am

Rodc wrote:
One should focus on what is under your control. Set some more or less reasonable asset allocation between stocks and bonds (split those up if you wish into subasset classes) based on a broad long term view of the market, if long term prospects look poor save more than otherwise or lower expectations. If long term prospects look good, ignore, do not reduce savings because it is so easy to be wrong, and don't get caught up in day dreaming about all the money you are going to make as it is so easy to be wrong.


Your conclusion that the best approach is to set a fixed asset allocation sounds to me like a foregone conclusion.
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Re: Do you adjust your AA based on valuations?

Postby Rodc » Thu May 16, 2013 11:13 am

grayfox wrote:
Rodc wrote:
One should focus on what is under your control. Set some more or less reasonable asset allocation between stocks and bonds (split those up if you wish into subasset classes) based on a broad long term view of the market, if long term prospects look poor save more than otherwise or lower expectations. If long term prospects look good, ignore, do not reduce savings because it is so easy to be wrong, and don't get caught up in day dreaming about all the money you are going to make as it is so easy to be wrong.


Your conclusion that the best approach is to set a fixed asset allocation sounds to me like a foregone conclusion.


Not really. I have done a lot of work on this personally as well as read work of others. Then there is just plain old common sense (need bold moves to get bold results, signal to noise is extreme so not much use). This has all led to the conclusion that there is no expected benefit from valuation timing strategies for me.

Add to that I have not seen any mutual funds able to pull this off (do you have some in mind?), so that begs the question of how you or I are going to pull this off.

After a lot of thought and work I have come to this conclusion, which is a far cry from it being a foregone conclusion. And to be fair, I did not say fixed allocation was optimal, only that the case for valuation timing is very weak, and the case for small movement valuation timing is even weaker. It is sort of an Occam's Razor deal: in the absence of a convincing case to the contrary the thing to do is the simple thing.
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Re: Do you adjust your AA based on valuations?

Postby Rodc » Thu May 16, 2013 11:30 am

grayfox wrote:
Rodc wrote:I confess that seems a little like the tail wagging the dog to me.

Any estimates of stock returns and risk going forward are so likely to be hugely wrong for one thing that this approach seems more wishful thinking than actual sound planning.



One thing you are missing is that, while there is great uncertainty in what a stock investment will return, there is little to no uncertainty in what a TIPS bond investment will return. When 30-year TIPS are yielding 0.7% real, that is pretty much what you are gong to get. Another way of saying that is, there is almost a perfect forecast for TIPS returns.

So if you have a fixed 50/50 TIPS/stock allocation no matter what interest rates are, then half the portfolio is virtually guaranteed to not meet you goal. It doesn't make sense to continue buying them in the same proportion regardless of interest rates.


I certainly think if you are going to use a valuation based timing strategy you should consider that prospects for all assets, not just stocks as is often done. (see my first post).

That does not make targeting or believing you can target, a fixed return with any useable degree of accuracy reasonable. Nor does a poor return in bonds mean you can handle the risk of a higher stock allocation. If TIPS were at -1% real and stocks had a P/E10 of 44, would you still advocate for skipping TIPS?

This strikes me as yet another approach for sweeping the real issue under the rug: the world is uncertain and we need to deal with that directly rather than pretending the world is not uncertain and we can make accurate enough predictions to actually tame the uncertainty.

If bonds stink, rather than pouring money into stocks and increasing our risk, for many the better approach is to save more or limit expectations. Our savings rate and expectations we can control.

It is also worth remembering, I think, that something like hitting 2% real with each monthly (etc.) investment is not the goal. The goal is to have enough money to accomplish something (college for the kids, retirement). A real return of 2% (in your example) is only one way to get there. I suggest being overly focused on a particular month by month target return is a bit myopic. A broader view of how to accomplish the goal might be useful.
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Re: Do you adjust your AA based on valuations?

Postby Scooter57 » Thu May 16, 2013 11:56 am

Rodc wrote:
I certainly think if you are going to use a valuation based timing strategy you should consider that prospects for all assets, not just stocks as is often done. (see my first post).

That does not make targeting or believing you can target, a fixed return with any useable degree of accuracy reasonable. Nor does a poor return in bonds mean you can handle the risk of a higher stock allocation. If TIPS were at -1% real and stocks had a P/E10 of 44, would you still advocate for skipping TIPS?

<snip>

It is also worth remembering, I think, that something like hitting 2% real with each monthly (etc.) investment is not the goal. The goal is to have enough money to accomplish something (college for the kids, retirement). A real return of 2% (in your example) is only one way to get there. I suggest being overly focused on a particular month by month target return is a bit myopic. A broader view of how to accomplish the goal might be useful.


+1

It is worth remembering that it isn't outside of the bounds of possibility that stocks and bonds could both become poor ways of investing under certain circumstances. There are times (rare, but they happen) when putting your money into property is the only way to ensure it doesn't lose all its value. There are times when if you have enough assets buying a local business will generate more income than buying shares in companies whose management is entirely out of your control. There are even times when buying gold coins and diamonds and sewing them into the hems of your garments is appropriate. Ask anyone Jewish who got out of Nazi Germany in 1938 how their stock and bond investments worked out.

The way most of us invest is the way that works the best most of the time. But to assume it will work best all of the time and that it will work best when we most need our money--when we are old and unable to work--could be a dangerous mistake.

So I believe we do have to keep a weather eye out for what is going on, and revisit the underlying assumptions that we used to craft our investment plan. If that plan was based on the assumption that bonds would compound in a way that doubles money every 10-15 years, the 1.5% interest rate should make us rethink that assumption. If our assumption was that stocks should yield 10% a year on average or even 7%, the fact that they have not earned anywhere near that much on an annual basis for the past 12 years should make you reconsider any plan that requires your money to earn that kind of return.
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Re: Do you adjust your AA based on valuations?

Postby pkcrafter » Thu May 16, 2013 12:16 pm

John3754 wrote:Forgive me I'm an unsophisticated investor...equities are "overvalued" and bonds are in a "bubble", so where's my money supposed to go at present?


John, sorry your question was ignored. Without knowing what you're holding, I'd say you should stick with your chosen asset allocation and current bond holdings. There will always be times then investing will feel uncomfortable and times when it can evoke fear. Having said that, it's also important to hold a well-balanced portfolio that can stand up to these emotional challenges.

As for timing, it's usually not something Bogleheads would do, and I'm really surprised at the activity in this thread. If you are concerned about current valuations, you might learn about tactical asset allocation as Taylor shows above, which means only limited changes would be made and probably not more than once a decade. In general, the more fiddling you do with your portfolio the more mistakes you are going to make, so it's important to limit opportunities to make the wrong move. And when you do make some tactical move, limit the adjustment because there is a good chance you've guessed wrong.

The last time P/E 10 was this high was in 1995. So, for those who got out at that point, they missed the following. In other words, they guessed wrong.

1995 - 34.11%
1996 - 20.26%
1997 - 31.01%
1998 - 26.67%
1999 - 19.53%

It's also worth noting that aside from today and 1995, the only other time P/E 10 was this high was in the late 1920's.


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Re: Do you adjust your AA based on valuations?

Postby grayfox » Thu May 16, 2013 3:51 pm

Rodc wrote:
grayfox wrote:
Your conclusion that the best approach is to set a fixed asset allocation sounds to me like a foregone conclusion.


Not really. I have done a lot of work on this personally as well as read work of others. Then there is just plain old common sense (need bold moves to get bold results, signal to noise is extreme so not much use). This has all led to the conclusion that there is no expected benefit from valuation timing strategies for me.



I know you have looked at this in depth, and I've read a many of your posts about the uncertainty of parameters. I'm not disagreeing that there is uncertainty in the parameters of stock returns, I've studied it as well. However, from reading your posts on the subject, I think you have looked at it and basically thrown your hands up and concluded "I give up, we don't know anything, just put 50% in stocks and 50% bonds."

But I think you overstate the amount of uncertainty. It's not a complete opaque box about which nothing is known. The uncertainty can be quantified to some extent. For example, suppose we know the mean return of stocks is 4% real, but there is uncertainty in that parameter. Let's say we estimate the error and we have 95% confidence that the true mean return is in interval 0 to 8%.

If TIPS were yielding 2%, I might be inclined to take the 2% sure thing rather than gamble on 0 to 8% with stocks, even though the odds are that stocks will do better.

But suppose TIPS are yielding 0%, which is known exactly. If there is 100% chance of bonds returning 0, and 95% chance of stocks returning 0 to 8%, how would you bet? I would bet on stocks, and hope for the 0 to 8, rather than the sure 0. Perhaps there is 2.5% chance bonds will beat stocks. But I will bet on the 97.5% chance.
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Re: Do you adjust your AA based on valuations?

Postby Scooter57 » Thu May 16, 2013 4:38 pm

pkcrafter wrote:[
The last time P/E 10 was this high was in 1995. So, for those who got out at that point, they missed the following. In other words, they guessed wrong.

1995 - 34.11%
1996 - 20.26%
1997 - 31.01%
1998 - 26.67%
1999 - 19.53%

It's also worth noting that aside from today and 1995, the only other time P/E 10 was this high was in the late 1920's.

Paul


This is a very bad example because the data suggest that your investor who left the market in 1995 would have done BETTER in long bonds over the decade following 1995 than they would have if they had stayed in.

Here's the detailed version of that scenario: Let's say that you started buying stocks in 1980 when the S&P was at 135. At that time tyou invested $100,000. By the end of 1995 the S&P is up to 616 so your original investment is now 4.5 times what you started with at $450000, but since you've been getting 5-6% a year in dividends through those 15 years, the dividends have doubled the original investment over that 15 years. So you now have $900,000--9 times as much money as they originally invested.

That's a hefty gain--enough to live comfortably on through retirement, and no one knows in 1995 that something called the Internet is going to explode the next year, so rather than gambling your retirement money any more, you decide to heed the message of the PE ratio and take all your money out and put it into safe bonds.

Long treasuries are paying 7.78% at the end of 1995, which means you can buy 9-10% on corporate bonds and about the same on tax-free muni bonds. You put your money into a Vanguard Tax Exempt long muni bond fund paying 7.78%

For the next 4 years you are kicking yourself that you didn't stay in the market. But you are still getting a compounded 7.78% each year, so by the end of 4 years you are still up another 36% just from interest.

By 2001 you are feeling a lot better about your investment choice as the market tanks. By 2002 the S&P has dropped back to 812 , which is only 31% higher than where you sold your stock. But by 2001 your compounding muni interest has earned you a total of 72.3% of your $900,000 investment, so you now have twice as much gain in your nice safe bond fund as you would have got had you left your money in the market with a "buy and hold" strategy. You're up to $1,550,700.

By 2005 the market has recovered some, and the S&P is up to 1180. That's 92% higher than where you sold out, but your total interest from your 10 years in the long bond fund is now up to 118% of your original investment. So your bond investment has earned 26% more than you would have earned had you left your money in the market the whole time. (You would have gotten some interest from a continuing stock market investment, though not anywhere near as much since most of the stuff shooting up wasn't paying dividends and dividends dropped during this whole period. Many of your dividends would have been reinvested at top-of-the-market prices, too which would have reduced your real take.)

So in this case, you would have done perfectly well if you'd gotten out of the market when the PE ratio hit that high. The market gains you lost, were, for the most part, short term and at many times nonexistent.

This isn't theoretical for me. I stayed out of the dot com boom because I knew too much about web sites and web businesses to believe that the dot com stocks could ever live up to any of the hype. I stuck with boring old long bond funds and ended up doubling my money according to that boring old rule of 72. I slept well in 2002 I slept well in 2009. I'll sleep well the next time the market takes away the specious gains reflected in high PE ratios.

And because I have enough to cover my retirement needs and then some, I'm content to wait patiently for long term interest rates to come back to where they will perform that Magic of Compounding trick for me--or my heirs--again.
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Re: Do you adjust your AA based on valuations?

Postby Rodc » Thu May 16, 2013 4:40 pm

basically thrown your hands up and concluded "I give up, we don't know anything, just put 50% in stocks and 50% bonds."

But I think you overstate the amount of uncertainty. It's not a complete opaque box about which nothing is known.


I'm sorry you feel this way. It is not uncommon. Some people see the world in black and white. If I say we don't know as much as you think, you hear "We don't know anything, toss your hand in the air, or stick your head in the ground". I have yet to figure out how to deal with folks who jump to that conclusion. So I'll just let my posts stand on their own merits and let people make of them what they will.
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Re: Do you adjust your AA based on valuations?

Postby grayfox » Thu May 16, 2013 6:41 pm

Don't take it personally. I find that your posts are insightful and original. I'm just pointing out that there are different parameters for the various assets, that are known with varying degrees of precision. Many parameters are known with poor precisely. Some parameters are known with greater precision. And a few parameters are known exactly.

For example, just yesterday, May 15, 2013 I had a zero-coupon U.S. Treasury mature. It paid exactly what I expected to the penny. I knew what the return would be the second I click the BUY button years ago. Of course, there was a one in a million chance the U.S. government would stiff me, but I rounded that to zero.
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Re: Do you adjust your AA based on valuations?

Postby letsgobobby » Fri May 17, 2013 3:33 pm

My IPS calls for me to decrease my stock holdings by 10% when PE10 reaches 25. By the close today we should be about 24.5 and that is close enough to pull a partial rebalance today; I was out of balance anyway (although within tolerances), due to the recent runup. A few more days like this, and we'll be over 25 and then I will complete the rebalance, which would take me down to 56% stocks. Age 39.

PE10 25 does not predict great 10 or 20 year returns for stocks, and you still get all their volatility and risk.
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Re: Do you adjust your AA based on valuations?

Postby jeffyscott » Sat May 18, 2013 8:42 am

Scooter57 wrote:I stuck with boring old long bond funds and ended up doubling my money according to that boring old rule of 72. I slept well in 2002 I slept well in 2009. I'll sleep well the next time the market takes away the specious gains reflected in high PE ratios.

And because I have enough to cover my retirement needs and then some, I'm content to wait patiently for long term interest rates to come back to where they will perform that Magic of Compounding trick for me--or my heirs--again.


My (long term) regrets have never been to wish I'd had even more in stocks when they had gone up, instead I regret things like not buying more I-bonds and TIPS when they offered a 3%+ real in the late 1990s.

But where do you wait now? Long term corporate bonds at about 4.1% at least do still offer positive expected real returns.
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Re: Do you adjust your AA based on valuations?

Postby jeffyscott » Sat May 18, 2013 9:12 am

Scooter57 wrote:So I believe we do have to keep a weather eye out for what is going on, and revisit the underlying assumptions that we used to craft our investment plan. If that plan was based on the assumption that bonds would compound in a way that doubles money every 10-15 years, the 1.5% interest rate should make us rethink that assumption. If our assumption was that stocks should yield 10% a year on average or even 7%, the fact that they have not earned anywhere near that much on an annual basis for the past 12 years should make you reconsider any plan that requires your money to earn that kind of return.


And yet, Vanguard Wellington has returned 7.2% over the last 15 years, this happens to be very similar to my own lifetime IRR (7.4% over past 15-1/2 years).
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Re: Do you adjust your AA based on valuations?

Postby YDNAL » Sat May 18, 2013 10:33 am

Rodc wrote:So far no.

1) you can't look at stocks in isolation, you must think about the portfolio as a whole. If stocks stink (high valuation) and other assets are even more over priced (say bonds have negative real yield) should you really be selling stocks to buy bonds? All stock valuation trading studies I have ever seen, including some I have done, suffer this serious flaw.

2) rebalancing helps a little, but frankly you tend to be buying and selling so little so infrequently that most of the time it has little effect. The rare occasion when the markets go crazy it is useful. Say when markets really crash, then rebound. (no guarantee of a nice rebound though).

3) minor shifts due to changing valuations will not have a significant impact, good or bad. You have to make big bold moves to get a big bold impact. I don't think the risk return trade off from big bold moves is generally favorable. IMHO, not worth the bother to make small timid moves, so I just keep on keeping on ignoring valuations.

4) as I near retirement (say 6-10 years off), if the market soars or crashes in a dramatic fashion I might find myself in a rather different situation than I had planned, where the risk reward trade off changes far from expected, I could imagine a one time variance from my current practice. For example if we have the stock market soaring to P/E10 of 44, I might very well take more off the table than simply rebalancing. But maybe not.

I agree with Rodc, for the most part, except that PE 10 above 35 signal irrational [earnings-based] fair market pricing to ME. It should go without saying that history does NOT necessarily repeat, but it is there to be understood.
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  • I don't believe that potential mid-term risk [say ensuing decade] at PE 10 of 20, 25 equates to PE 10 of 35, 40, 44 (a la 1999).
  • Closer to retirement (or in retirement), capital preservation is MORE important than some variation* in expected real return.
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Re: Do you adjust your AA based on valuations?

Postby Scooter57 » Sat May 18, 2013 1:59 pm

jeffyscott wrote:My (long term) regrets have never been to wish I'd had even more in stocks when they had gone up, instead I regret things like not buying more I-bonds and TIPS when they offered a 3%+ real in the late 1990s.

But where do you wait now? Long term corporate bonds at about 4.1% at least do still offer positive expected real returns.


I'm with you. I deeply regret not buying 10 year CDs back in the period 1989-2005 when they were paying decent rates. But in those days I never knew when the family would need the money we'd saved, so I didn't want to tie it up too long. And of course, with the rates they were paying then, the interest penalties meant something.

As far as where to put money today, for those of us nearing retirement, my feeling is that we do have to be patient and invest in the market only to the extent that would let us sleep happily if the market were to drop 50% or more. Rates will eventually go up, and if we have serious inflation, they'll go up a lot faster.

I am fortunate to have enough saved that I don't have to grow what I have faster than inflation, so I can live with the low CD rates for now. If, or perhaps I should say, when, the market corrects, I'll have another look at the classic blue chip staid, boring low volatility dividend stocks that have been profitable in downturns before and buy into them. But at today's valuations little in that category makes sense to me.

Vanguard's Dividend Growth Fund is a good way to buy that kind of stock, but right now the valuations are high enough that I wouldn't make any large new investments until we get a correction that lowers the PE to a more reasonable level and pushes up the dividend yield to more traditional levels.
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Re: Do you adjust your AA based on valuations?

Postby lazyday » Sat May 18, 2013 4:28 pm

jeffyscott wrote:But where do you wait now?

If you find expected returns for US stocks unacceptably low
- ibonds, EE if have 20 year timeframe, CDs with low early withdrawal penalty, some cash
- Ex-US equity. Maybe not cheap, but some think has better expected return

If my only choices today were US TSM or cash, I’d have more cash than I do. Would risk never being able to buy into stocks at today’s prices, or even at a much higher price. Could easily happen. Estimated returns for US TSM have been low for a while, and the market keeps rising. With interest rates so low, money is driven to the stock market. Just wouldn’t count on it.

I generally agree with earlier poster about using SAA/TAA gently, according to the advice of people like Bogle.

Possible exception might be when bond real yield is more than expected return of stocks, not true today.

(Just as aside, should admit I can be aggresive in my own portfolio, but never suggest for others. I have suffered huge losses, such as ~1998 probably well over 50% for a time.)
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Re: Do you adjust your AA based on valuations?

Postby Ged » Sat May 18, 2013 9:53 pm

I allow myself some flexibility on what my new contributions go into based on valuation. The thing is that right now bonds are also extremely highly valued, as are my US REITs. The assets that aren't highly valued are non-US assets. So I'm buying more non-US assets.

The other aspect of the current situation is that there is a lot of slack in the economy. Unemployment is high, resource costs are reasonable, capacity utilization is low and businesses have little debt, lots of cash and can borrow cheaply. This suggests the E in P/E has room to grow. It's often said the price of a stock is based on discounted future earnings. So while the potential for PE10 of 24 to be too high there is also a potential for stock prices to grow because of the slack in the economy. So basically I don't feel that one can predict a future downturn in stock prices right now.
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Re: Do you adjust your AA based on valuations?

Postby jeffyscott » Wed May 22, 2013 5:22 pm

lazyday wrote:
jeffyscott wrote:But where do you wait now?

If you find expected returns for US stocks unacceptably low
- ibonds, EE if have 20 year timeframe, CDs with low early withdrawal penalty, some cash
- Ex-US equity. Maybe not cheap, but some think has better expected return


Yes, I am doing all of that and have just 23% in US stocks, but that was actually related to the poster who is waiting for long term bond rates to offer better returns.
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Re: Do you adjust your AA based on valuations?

Postby mlewis » Wed May 22, 2013 11:28 pm

My answer is no, but I would like to theoretically. I haven't found any way to work this into a strategy at this point. I don't want to start doing something then change it around all the time that's for sure. I wan't to be really sure of it. There certainly isn't any perfect answer, and it's a moving target of sorts as we continue to learn more about the market.

To all those that pass this idea aside as a form of "market timing." Isn't rebalancing "market timing?"
If rebalancing is just a way to control risk, then why wouldn't you adjust AA based on valuations? After all, is a risk of a big market drop really the same with different valuations? I doubt it. Or in other words, maybe you should rebalance less often. . .
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Re: Do you adjust your AA based on valuations?

Postby kenyan » Thu May 23, 2013 11:21 am

Everything is bad right now. The US market is frothy. Japan has been soaring. Small Value has risen too much. Dividend stocks are in a bubble. REITs are overvalued. Nominal bonds have terrible yields and are about to crash. TIPS have negative real yields. Cash is earning zero nominal. CDs are at all-time low yields. Spreads are shrinking on risky instruments as people stretch for yield. Gold is crashing but still well above its expected price.

Where exactly should one be investing? I'm not saying that you should always ignore valuations, but if everything is overvalued, it's not clear what action is prudent. In the absence of that, I'm sticking with my diversified asset allocation, and not making market-timing bets.
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Re: Do you adjust your AA based on valuations?

Postby kenyan » Thu May 23, 2013 11:25 am

mlewis wrote: Isn't rebalancing "market timing?"


Everyone has their own definition, but 'market timing' is generally accepted to be an action based upon one's prediction of the future movement of markets. Rebalancing, in most cases, does not qualify - it's a mathematically predetermined action that doesn't care what the markets are going to do. It is the act of realigning your portfolio with your chosen risk posture. Moving back to your target has nothing to do with the future.
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Re: Do you adjust your AA based on valuations?

Postby Rodc » Thu May 23, 2013 1:09 pm

kenyan wrote:
mlewis wrote: Isn't rebalancing "market timing?"


Everyone has their own definition, but 'market timing' is generally accepted to be an action based upon one's prediction of the future movement of markets. Rebalancing, in most cases, does not qualify - it's a mathematically predetermined action that doesn't care what the markets are going to do. It is the act of realigning your portfolio with your chosen risk posture. Moving back to your target has nothing to do with the future.


This has been beat to death in many threads if one wants to look. I agree that this is the majority view and seems sensible to me. There is also the issue of where on a spectrum something sits. Even if one wants to argue that rebalancing is market timing the amounts moved around are so small it amounts to a who cares.

As to why wouldn't rebalance on valuations, you certainly could. But again the amounts being moved are generally so small that it just does not matter.
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Re: Do you adjust your AA based on valuations?

Postby letsgobobby » Thu May 23, 2013 1:39 pm

Rodc wrote:As to why wouldn't rebalance on valuations, you certainly could. But again the amounts being moved are generally so small that it just does not matter.


It doesn't have to be small. My stock exposure ranged from < 10% in 2000 (PE10 45) to almost 70% in 2009 (PE10 as low as 12). Now 59% at pE10 24. You can say I was lucky, to which I say "better lucky than good!" But the amounts being moved are not that small.

My IPS allows me to range +/- 30% stock exposure depending on PE10. That's enough to move the needle, I think.
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Re: Do you adjust your AA based on valuations?

Postby kenyan » Thu May 23, 2013 1:51 pm

Rodc wrote:
kenyan wrote:
mlewis wrote: Isn't rebalancing "market timing?"


Everyone has their own definition, but 'market timing' is generally accepted to be an action based upon one's prediction of the future movement of markets. Rebalancing, in most cases, does not qualify - it's a mathematically predetermined action that doesn't care what the markets are going to do. It is the act of realigning your portfolio with your chosen risk posture. Moving back to your target has nothing to do with the future.


This has been beat to death in many threads if one wants to look. I agree that this is the majority view and seems sensible to me. There is also the issue of where on a spectrum something sits. Even if one wants to argue that rebalancing is market timing the amounts moved around are so small it amounts to a who cares.

As to why wouldn't rebalance on valuations, you certainly could. But again the amounts being moved are generally so small that it just does not matter.


Agreed - it's in the 'who cares' category. I think it gets beat to death around here because of the board-specific stigma associated with market timing.
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Re: Do you adjust your AA based on valuations?

Postby Rodc » Thu May 23, 2013 4:58 pm

letsgobobby wrote:
Rodc wrote:As to why wouldn't rebalance on valuations, you certainly could. But again the amounts being moved are generally so small that it just does not matter.


It doesn't have to be small. My stock exposure ranged from < 10% in 2000 (PE10 45) to almost 70% in 2009 (PE10 as low as 12). Now 59% at pE10 24. You can say I was lucky, to which I say "better lucky than good!" But the amounts being moved are not that small.

My IPS allows me to range +/- 30% stock exposure depending on PE10. That's enough to move the needle, I think.


The post I responded to was about rebalancing. "Generally" was the operative word. Rebalancing is most often a few percent here or there and not too often. But occasionally the world goes crazy. Hence I wrote "generally", not "always".

A more general timing strategy would be a different topic, and you could choose to move any amount you want.
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Re: Do you adjust your AA based on valuations?

Postby Rodc » Thu May 23, 2013 4:59 pm

kenyan wrote:
Rodc wrote:
kenyan wrote:
mlewis wrote: Isn't rebalancing "market timing?"


Everyone has their own definition, but 'market timing' is generally accepted to be an action based upon one's prediction of the future movement of markets. Rebalancing, in most cases, does not qualify - it's a mathematically predetermined action that doesn't care what the markets are going to do. It is the act of realigning your portfolio with your chosen risk posture. Moving back to your target has nothing to do with the future.


This has been beat to death in many threads if one wants to look. I agree that this is the majority view and seems sensible to me. There is also the issue of where on a spectrum something sits. Even if one wants to argue that rebalancing is market timing the amounts moved around are so small it amounts to a who cares.

As to why wouldn't rebalance on valuations, you certainly could. But again the amounts being moved are generally so small that it just does not matter.


Agreed - it's in the 'who cares' category. I think it gets beat to death around here because of the board-specific stigma associated with market timing.


Just to be clear, my intent was to back you up. My response was to mlewis.
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Re: Do you adjust your AA based on valuations?

Postby kenyan » Thu May 23, 2013 5:24 pm

Rodc wrote:
Just to be clear, my intent was to back you up. My response was to mlewis.


Yep, understood (both now and when I replied).
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Re: Do you adjust your AA based on valuations?

Postby Rodc » Thu May 23, 2013 6:40 pm

Good! Hard to tell sometimes on the internet.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Re: Do you adjust your AA based on valuations?

Postby letsgobobby » Wed Jun 05, 2013 4:14 pm

letsgobobby wrote:My IPS calls for me to decrease my stock holdings by 10% when PE10 reaches 25. By the close today we should be about 24.5 and that is close enough to pull a partial rebalance today; I was out of balance anyway (although within tolerances), due to the recent runup. A few more days like this, and we'll be over 25 and then I will complete the rebalance, which would take me down to 56% stocks. Age 39.

PE10 25 does not predict great 10 or 20 year returns for stocks, and you still get all their volatility and risk.


Hark, all ye valuation doubters! Since this incredibly prescient move based on PE10, the market is down an astounding 2.18%! Can't you see how powerful and amazing valuation-based asset allocation can be? :mrgreen:
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