Personal Asset Allocation Based on Graham Rather than Age

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jar2574
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Personal Asset Allocation Based on Graham Rather than Age

Post by jar2574 »

I love the Boglehead approach to index funds and low cost investing. But I find myself drifting away from most Bogleheads on the issue of asset allocation.

Strict age-based formulas for stock/bond asset allocation do not take prices into account. I don't buy anything else without considering the price, so why make an exception for stocks?

I am also not comfortable with the age-based approach because stock prices are not related to my age. So under an age-based plan I might buy stocks "high" while I'm young and have to sell them "low" when I'm older.

I have tried to think of alternatives and would like to hear comments on the approach I'm about to outline.

Graham suggests in The Intelligent Investor that, as a general rule: "Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio -- the reverse of the P/E ratio -- at least as high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%."

The "earnings/price ratio" is often called "earnings yield." Using Graham's quote as a guide, and using his idea that a person's stock/bond allocation should be between 75-25 and 25-75, my idea is that my asset allocation will be based on a comparison of the S&P 500's "earnings yield" to AA bond yield. Here are my proposed allocations:

Earnings yield at more than 120% of bond yield = 75% stocks
Earnings yield at 110%-120% of bond yield = 65% stocks
Earnings yield at 100%-110% of bond yield = 55% stocks
Earnings yield at 90-100% of bond yield = 45% stocks
Earnings yield at 80-90% of bond yield = 35% stocks
Earnings yield at less than 80% of bond yield = 25% stocks

I would love to hear about any research that has been done on portfolios of this type. Surely someone has done something like this, right?

Any constructive criticism is also welcome. But for the sake of this discussion, please assume that I have a very high risk tolerance and plenty of capital to stick with the plan. Thanks very much.
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stratton
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Post by stratton »

I'm not sure it will work any more. Before 1958 stocks yielded more than bonds. Since then no. You could do this with a high yield basket of stocks, but they have a tendency towards indusry concentration in things like financials.

Go to www.ssrn.com and do a search on "price earnings ratio". It will pop up about 200 papers. No obvious direct link so you'll have to do it manuall.

Paul
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jar2574
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Post by jar2574 »

stratton wrote:I'm not sure it will work any more. Before 1958 stocks yielded more than bonds. Since then no. You could do this with a high yield basket of stocks, but they have a tendency towards indusry concentration in things like financials.

Go to www.ssrn.com and do a search on "price earnings ratio". It will pop up about 200 papers. No obvious direct link so you'll have to do it manuall.

Paul
I think you're looking at "dividend yield" rather than "earnings yield."

Earnings yield is the inverse of the P/E ratio. For example, if the P/E ratio is 15, then the "earnings yield" is 6.67%. I would compare the 6.67% earnings yield to the bond yield to determine my allocation.

Thank you for the website. I have a lot of reading to do!
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stratton
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Post by stratton »

jar2574 wrote:
stratton wrote:I'm not sure it will work any more. Before 1958 stocks yielded more than bonds. Since then no. You could do this with a high yield basket of stocks, but they have a tendency towards indusry concentration in things like financials.
I think you're looking at "dividend yield" rather than "earnings yield."

Earnings yield is the inverse of the P/E ratio. For example, if the P/E ratio is 15, then the "earnings yield" is 6.67%. I would compare the 6.67% earnings yield to the bond yield to determine my allocation.
Oops on my part. I'm leaving my boo boo for posterity.

Now you have my interest. This ought to be an interesting thread.

Paul
dayzero
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Post by dayzero »

This approach has an underlying assumption that P/E has some predictive value for equity returns. Unfortunately that assumption is false. The E is the problem - it is either a) backward looking, and the past does not predict the future, or b) forward looking, and thus just a guess, and thus absolutely meaningless.

P/E market timing (which is what this approach boils down too) has been beaten to death around here. Do some searches on it.
linuxizer
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Re: Personal Asset Allocation Based on Graham Rather than Ag

Post by linuxizer »

That's a pretty conservative rule. Basically you're saying that the companies can't expect to earn any better than an AA grade bond. If that's the case, they should get out of the business they're in and become investment firms buying AA grade bonds of other companies instead. You expect absolutely zero long-term premium in exchange for assuming risk, which has historically not been the case.

I believe that Bogle has stated he is fine with up to 15% "tactical asset allocation" in either direction, so 30% total (someone correct me if I'm wrong here). This forum tends to discount that philosophy, but in the end it probably doesn't matter too much (although 30% is quite a bit).

The biggest problem with determining asset allocation based on P/E rather than on life events is that your need for the money is determined more by the latter than the former. What happens if you buy in at a P/E of 13 ten years before retirement, only to have the P/E drop to 10 for a decade? You'll then be forced to sell low due to life events. Asset allocation is about controlling risk, first and foremost; thus the age rule. Those with different life events foreseen (college, for one), should probably adjust accordingly.
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Post by CoderDude »

mike_slc wrote:This approach has an underlying assumption that P/E has some predictive value for equity returns. Unfortunately that assumption is false.
According to Robert Shiller, the PE ratio has had predictive value for equity returns:

http://en.wikipedia.org/wiki/File:Price ... ata%29.png
dayzero
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Post by dayzero »

Statistical association is not causation. You need causation for predictive power.
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Post by linuxizer »

mike_slc wrote:Statistical association is not causation. You need causation for predictive power.
When making a causal argument, barring double-blind placebo-controlled trials, you rely both on association and theoretical methods to make your argument. P/E would seem to have both of enough to say that there is a weak argument to be made in its favor. I think the bigger issue is that even if such an effect exists, it's not big enough to make up for the lack of a large number of events on which to average out the randomness. You might only get a handful of buying and selling opportunities in your lifetime, which makes the costs of a wrong turn very large indeed.
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jar2574
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Post by jar2574 »

mike_slc wrote:Statistical association is not causation. You need causation for predictive power.
A company earns $100,000 per year. I predict that I will have a better chance of earning money on my investment if I buy that company for $1.5 million than if I buy it for $4 million. This seems to be a sound prediction, no?
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Post by dayzero »

jar2574 wrote:A company earns $100,000 per year.
That is the problem. How do you know that? How do you know it won't earn $1,000,000 next year? $0?
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Post by dbr »

jar2574 wrote:
mike_slc wrote:Statistical association is not causation. You need causation for predictive power.
A company earns $100,000 per year. I predict that I will have a better chance of earning money on my investment if I buy that company for $1.5 million than if I buy it for $4 million. This seems to be a sound prediction, no?
You earn $100,000 per year either way, so no you cannot possibly earn more money because you bought at one price rather than the other.

A different question is how much gain you can make in the market with your asset in either case. If you buy the company for $1.5M and the market subsequently values the company at $1M you lose money. If you buy the company for $4M and the market subsequently values the company at $5M you make money, so no again.
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jar2574
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Post by jar2574 »

mike_slc wrote:
jar2574 wrote:A company earns $100,000 per year.
That is the problem. How do you know that? How do you know it won't earn $1,000,000 next year? $0?
In either situation, the price I paid to acquire the company affects the return on my investment.
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Post by dayzero »

Yes but your strategy does not only depend on price. It depends on price, which you know, and earnings, which you do not.
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jar2574
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Post by jar2574 »

mike_slc wrote:Yes but your strategy does not only depend on price. It depends on price, which you know, and earnings, which you do not.
Every allocation strategy depends on earnings that we do not know.

EDIT

To clarify: An age-based allocation will be based on historical returns and historical volatility. But we cannot be certain that those historical patterns will continue. So in that sense the strategy depends on earnings we do not know.
Last edited by jar2574 on Tue Apr 28, 2009 9:43 pm, edited 1 time in total.
maxwellthedog
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Post by maxwellthedog »

There is actually a sound theoretical underpinning for comparing the ratio of the yield on investment-grade corporate debt to the earnings yield of equivalent stocks (equivalent meaning large, investment-grade companies like the S&P 500 (which, admittedly, is not all investment grade)).

Corporate debt is senior to equity in the capital structure of a company. It comes in front of the equity in the event of a liquidation and also carries a series of guarantees that equity does not have (e.g. it can be secured, it can have positive and negative covenants, it can restrict the company from taking on more debt, etc). By being senior to the equity, the debt is safer. As such, it should have a lower yield.

If you buy equity at a time when it has a much lower earnings yield than debt (like the first half of 2008 when bonds fell, yields soared, and equities didn't do much), then you are passing up the opportunity to invest in a safer part of the capital structure and earn a higher yield. Opinions vary as to which is the leading indicator (i.e. higher debt yields mean equity prices are going lower, or lower debt yields mean equity prices can go higher)-- and the market changes over time. Right now, in a deleveraging-driven recession, debt yields have tended to lead the equity market.

But either way, your decision should be the same-- given the chance to invest in a safer security with a higher yield, you should take it. Despite what mike_slc wrote, price matters. A lot.

Thus spake Ben Graham.
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Post by saurabhec »

jar2574 wrote:
mike_slc wrote:Yes but your strategy does not only depend on price. It depends on price, which you know, and earnings, which you do not.
Every allocation strategy depends on earnings that we do not know.
Not if you fix your equity/bond mix. Then you are earnings agnostic. I think there is some value to looking at earnings and corporate yields, but the earnings yield has to be forward looking. This of course means that at inflection points your estimates of earnings and hence earnings yield will be wrong. The way I would use this comparision is to try to figure out if equities are in a bubble. Not worth it to avoid minor bubbles in my opinion, but once or twice in a lifetime it might be worth it to use such a comparision to temper equity allocations. The late 1990s were probably one such era.
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Post by maxwellthedog »

as far as when to tip your allocation, you should do some research on how earnings yields and corporate bond yields have varied over time. that will give you a better idea of when to tilt, and how much to tilt.

i use a similar approach (though i use a 10 year real PE ratio like the one Shiller publishes on his website). I also do not have nearly as many fine gradations in portfolio tilt. basically, it comes down to "underweight equities", "equal weight equities", and "overweight equities".

two or three different weight is likely more than enough. otherwise you will be spending all of your time trying to rebalance and figure out where you should be. this rule is a guideline-- not a hard and fast law.
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Post by maxwellthedog »

Sorry saurabhec, but i have to disagree. In the process of "fixing your equity/bond mix", everyone has to make some assumption about 1) how much risk they want to take on in their portfolio (which is mostly driven by the amount allocated to equities) and 2) what kind of return they want/hope to earn.

both equity volatility and future returns are directly related to the price at which you buy. and for a broad index, whose earnings basically track economic growth, trailing earnings will tend to be correlated with forward earnings (especially if you take a running multi-year average).

fixing your equity allocation does not make you earnings agnostic. just because you are ignoring the impact of earnings and price on your returns does not mean it is not going to affect you profoundly.
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Post by jar2574 »

maxwellthedog wrote:as far as when to tip your allocation, you should do some research on how earnings yields and corporate bond yields have varied over time. that will give you a better idea of when to tilt, and how much to tilt.

i use a similar approach (though i use a 10 year real PE ratio like the one Shiller publishes on his website). I also do not have nearly as many fine gradations in portfolio tilt. basically, it comes down to "underweight equities", "equal weight equities", and "overweight equities".

two or three different weight is likely more than enough. otherwise you will be spending all of your time trying to rebalance and figure out where you should be. this rule is a guideline-- not a hard and fast law.
Thanks. Good to hear from someone using a similar approach.

I like the 10 year P/E ratio too. Today I found a table of monthly S&P 500 ratios at this website that claims to use Shiller's P/E 10 data. http://www.multpl.com/table?f=m

I have been comparing these ratios to the AAA bond rates on the Federal Reserve's website. http://www.federalreserve.gov/releases/ ... AAA_NA.txt

I haven't been able to find any good tables on AA bond rates.

Do you mind me asking what your tipping points are? I agree that I might have too many gradiations. 66-33, 50-50, 33-66 allocations might be enough for me if I found the right tipping points.
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Post by Adrian Nenu »

Conservative stock/bond mix is the only way "buy & hold" will work. Stock heavy asset allocations will get periodically wiped out by bear markets when you least expect it and/or are able to recover from.

Adrian
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Risk

Post by nick22 »

In theory equity investors are receiving a risk premium over the risk free investment, Treasury bonds. So it does make sense to want to estimate future expected equity returns to estimate this risk premium. When the risk premium is high, it would make more sense to invest in equities.

However, I am not sure if this can be easily done without significant guess work. I am not sure that earnings yield or any other metric is highly correlated with future returns. So if it can only be calculated in hindsight, buy and hold makes the most sense.
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Post by jar2574 »

maxwellthedog wrote:There is actually a sound theoretical underpinning for comparing the ratio of the yield on investment-grade corporate debt to the earnings yield of equivalent stocks (equivalent meaning large, investment-grade companies like the S&P 500 (which, admittedly, is not all investment grade)).

Corporate debt is senior to equity in the capital structure of a company. It comes in front of the equity in the event of a liquidation and also carries a series of guarantees that equity does not have (e.g. it can be secured, it can have positive and negative covenants, it can restrict the company from taking on more debt, etc). By being senior to the equity, the debt is safer. As such, it should have a lower yield.

If you buy equity at a time when it has a much lower earnings yield than debt (like the first half of 2008 when bonds fell, yields soared, and equities didn't do much), then you are passing up the opportunity to invest in a safer part of the capital structure and earn a higher yield. Opinions vary as to which is the leading indicator (i.e. higher debt yields mean equity prices are going lower, or lower debt yields mean equity prices can go higher)-- and the market changes over time. Right now, in a deleveraging-driven recession, debt yields have tended to lead the equity market.

But either way, your decision should be the same-- given the chance to invest in a safer security with a higher yield, you should take it. Despite what mike_slc wrote, price matters. A lot.

Thus spake Ben Graham.
Thanks for this post. A much more cogent explanation of the theory behind Graham's approach than I was able to offer.
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Post by saurabhec »

maxwellthedog wrote:
fixing your equity allocation does not make you earnings agnostic. just because you are ignoring the impact of earnings and price on your returns does not mean it is not going to affect you profoundly.
You are misunderstanding what I said. Of course I don't mean to suggest that valuation does not impact future returns. It obviously is a huge factor. What I am saying is that my asset allocation mix does not depending on forecasting earnings, it depends more on my risk tolerance. Also if the original poster is going to use a valuation metric to time equity exposure, then to be reliable it has to be based on future earnings, and not past earnings, especially if the concern is to avoid bubble risk. Earnings can be tremedously volatile at inflection points in bubbles.

Just for the record, I actually chose to go into zero equities in late 1998 and did not own equities again till 2000 (modest allocation). That was obviously a market timing call, but it was a once in a lifetime sort of decision, not something I would make a habit of. Certainly in 2007 I would not have made the same call, regardless of concerns about credit. Equity valuation multiples seemed rich, but not crazy rich, and not sufficient to shift my asset allocation greatly (which happened to be very low, only recently has it gone up above 40%, on its way to 50%). For example, no matter how undervalued I feel the market might be relative to future earnings, I doubt I will ever exceed more than 60% in equities, and if it gets above that level due to a bull market I will sell to get it back in line with my risk tolerance.
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Post by White Coat Investor »

I don't think it is a bad approach. But I would use keep two caveats in mind:

1) The "default" investing method for everyone should be a "boglehead-style" fixed asset allocation "know-nothing" portfolio.

2) Keep your swings in AA within the range Bogle has set. Sure 30% (15% each way) seems like a lot, but it is much less than the 100% you see lots of very unsuccessful investors using. Always think about not only the possibility of being wrong, but also the consequences of being wrong.

If I (75/25) had gone to 60/40 before the downturn, I'd be better off, and if I had changed magically to 90/10 on Mar 9th, I'd be much better off, but I would still have lost a big chunk of change over the last 18 months. Something like this is fine tuning around the edges, not a major part of an investing strategy.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course
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jar2574
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Post by jar2574 »

saurabhec wrote:
maxwellthedog wrote:
fixing your equity allocation does not make you earnings agnostic. just because you are ignoring the impact of earnings and price on your returns does not mean it is not going to affect you profoundly.
Also if the original poster is going to use a valuation metric to time equity exposure, then to be reliable it has to be based on future earnings, and not past earnings, especially if the concern is to avoid bubble risk. Earnings can be tremedously volatile at inflection points in bubbles.
P/E 10 doesn't seem to have those volatility problems around bubbles.

I don't trust future earnings estimates. To steal a line from Buffett, "future projections are of no interest to us."
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Post by saurabhec »

jar2574 wrote: P/E 10 doesn't seem to have those volatility problems around bubbles.

I don't trust future earnings estimates. To steal a line from Buffett, "future projections are of no interest to us."
I agree that it is hard to project future earnings, which is the achilles heel of any P/E based strategy because investors only care about earnings in the future. Variance from expectations there is what takes stocks down. If you used your own metric at the end of 2007, I don't think it would show that stocks were grossly overvalued relative to corporate bonds. In fact it might even show that they were undervalued.

I think things like P/E 10 are handy to get a helicopter view of valuations, but as a market timing tool, I would not rely on it. If such a simple pattern were to be highly reliable and predictive, then it would get arbitraged away and cease to exist at some point in the future.

In general, it is unlikely that an investor will run into more than 2-3 major bubbles in their investment lifetime. So I can't say I endorse an active market timing strategy just because of the desire to avoid bubbles. I say this as someone who made a major market timing decision in late 1999 that turned out to be right.
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Re: Personal Asset Allocation Based on Graham Rather than Ag

Post by Valuethinker »

jar2574 wrote:I love the Boglehead approach to index funds and low cost investing. But I find myself drifting away from most Bogleheads on the issue of asset allocation.

Strict age-based formulas for stock/bond asset allocation do not take prices into account. I don't buy anything else without considering the price, so why make an exception for stocks?

I am also not comfortable with the age-based approach because stock prices are not related to my age. So under an age-based plan I might buy stocks "high" while I'm young and have to sell them "low" when I'm older.

I have tried to think of alternatives and would like to hear comments on the approach I'm about to outline.

Graham suggests in The Intelligent Investor that, as a general rule: "Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio -- the reverse of the P/E ratio -- at least as high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%."

The "earnings/price ratio" is often called "earnings yield." Using Graham's quote as a guide, and using his idea that a person's stock/bond allocation should be between 75-25 and 25-75, my idea is that my asset allocation will be based on a comparison of the S&P 500's "earnings yield" to AA bond yield. Here are my proposed allocations:

Earnings yield at more than 120% of bond yield = 75% stocks
Earnings yield at 110%-120% of bond yield = 65% stocks
Earnings yield at 100%-110% of bond yield = 55% stocks
Earnings yield at 90-100% of bond yield = 45% stocks
Earnings yield at 80-90% of bond yield = 35% stocks
Earnings yield at less than 80% of bond yield = 25% stocks

I would love to hear about any research that has been done on portfolios of this type. Surely someone has done something like this, right?

Any constructive criticism is also welcome. But for the sake of this discussion, please assume that I have a very high risk tolerance and plenty of capital to stick with the plan. Thanks very much.
Of the 'value' strategies that work, empirically, price to book has the strongest long run performance. Bottom decile outperforms credibly (but not necessarily after tax and dealing costs).

But if you buy low price to book stocks, you are buying some real rubbish. What you are buying is the chance that in the left tail solution on the economy (depression or credit crisis) that many of those companies will go broke. You might for example wind up with a portoflio of AIGs and Citigroups and Fannie and Freddie-- that's what happened to a lot of value managers last year.

Value outperforms, and it appears to outperform by more than the risk adjustment would allow.

But that suggests that our risk adjustment (beta) is incorrect, rather than that value is some magic formula that the market just misses.

Fama and French documented the 3 factor model (value, size, risk) in the early 90s and if you follow up on their papers there is a full debate.

On Graham I am somewhat supportive of behavioural explanations, but note that you can do a 'screen' on stocks these days, in Graham's day it was backbreaking work to dig out that info. So the market could be plausibly more efficient, and the inefficiencies less manifest.

Probably David Dreman is the most articulate modern exponent. Read his demolition of the small cap effect which he thinks is an artefact of the data.

If you want to do Graham, you are either going to pick your own stocks, or you are going to use funds like Mutual Beacon Discovery and Third Avenue Value and Cundill, all of which charge quite high fees.

Otherwise buy the DFA Small Cap Value product and enjoy the bumpy (but potentially lucrative) ride. The problem with index funds is finding ones that are 'valuey' enough-- ie bottom decile P/B.
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Re: Personal Asset Allocation Based on Graham Rather than Ag

Post by Valuethinker »

jar2574 wrote:I love the Boglehead approach to index funds and low cost investing. But I find myself drifting away from most Bogleheads on the issue of asset allocation.

Strict age-based formulas for stock/bond asset allocation do not take prices into account. I don't buy anything else without considering the price, so why make an exception for stocks?

I am also not comfortable with the age-based approach because stock prices are not related to my age. So under an age-based plan I might buy stocks "high" while I'm young and have to sell them "low" when I'm older.

I have tried to think of alternatives and would like to hear comments on the approach I'm about to outline.

Graham suggests in The Intelligent Investor that, as a general rule: "Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio -- the reverse of the P/E ratio -- at least as high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%."

The "earnings/price ratio" is often called "earnings yield." Using Graham's quote as a guide, and using his idea that a person's stock/bond allocation should be between 75-25 and 25-75, my idea is that my asset allocation will be based on a comparison of the S&P 500's "earnings yield" to AA bond yield. Here are my proposed allocations:

Earnings yield at more than 120% of bond yield = 75% stocks
Earnings yield at 110%-120% of bond yield = 65% stocks
Earnings yield at 100%-110% of bond yield = 55% stocks
Earnings yield at 90-100% of bond yield = 45% stocks
Earnings yield at 80-90% of bond yield = 35% stocks
Earnings yield at less than 80% of bond yield = 25% stocks

I would love to hear about any research that has been done on portfolios of this type. Surely someone has done something like this, right?

Any constructive criticism is also welcome. But for the sake of this discussion, please assume that I have a very high risk tolerance and plenty of capital to stick with the plan. Thanks very much.
I should add you should read the Andrew Lo paper about the summer of 2008 (August 7th I believe).

Hedge Funds read the same academic papers we do. A hedge fund went into forced liquidation in that period, and the impact on value stocks was dramatic, and painful.
whocarez
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Re: Personal Asset Allocation Based on Graham Rather than Ag

Post by whocarez »

jar2574 wrote:I love the Boglehead approach to index funds and low cost investing. But I find myself drifting away from most Bogleheads on the issue of asset allocation.

Strict age-based formulas for stock/bond asset allocation do not take prices into account. I don't buy anything else without considering the price, so why make an exception for stocks?

I am also not comfortable with the age-based approach because stock prices are not related to my age. So under an age-based plan I might buy stocks "high" while I'm young and have to sell them "low" when I'm older.

I have tried to think of alternatives and would like to hear comments on the approach I'm about to outline.

Graham suggests in The Intelligent Investor that, as a general rule: "Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio -- the reverse of the P/E ratio -- at least as high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%."

The "earnings/price ratio" is often called "earnings yield." Using Graham's quote as a guide, and using his idea that a person's stock/bond allocation should be between 75-25 and 25-75, my idea is that my asset allocation will be based on a comparison of the S&P 500's "earnings yield" to AA bond yield. Here are my proposed allocations:

Earnings yield at more than 120% of bond yield = 75% stocks
Earnings yield at 110%-120% of bond yield = 65% stocks
Earnings yield at 100%-110% of bond yield = 55% stocks
Earnings yield at 90-100% of bond yield = 45% stocks
Earnings yield at 80-90% of bond yield = 35% stocks
Earnings yield at less than 80% of bond yield = 25% stocks

I would love to hear about any research that has been done on portfolios of this type. Surely someone has done something like this, right?

Any constructive criticism is also welcome. But for the sake of this discussion, please assume that I have a very high risk tolerance and plenty of capital to stick with the plan. Thanks very much.
And pure valuation based investment doesn't take into account my personal asset/liablility mismatches. I would rather have a middle ground.

Just to illustrate my point of view say something of this sort

Earnings yield at more than 120% of bond yield = (120 - Age)% stocks
Earnings yield at 110%-120% of bond yield = (110 - Age)% stocks
So on and so forth

Obviosuly actual figures might differ based on various factors
1. Investors risk appetite
2. Empirical studies
3. Tax treatment (In some countries there is a favourable tax treament on holding of stocks compared to bonds)
cjking
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Re: Personal Asset Allocation Based on Graham Rather than Ag

Post by cjking »

jar2574 wrote: The "earnings/price ratio" is often called "earnings yield." Using Graham's quote as a guide, and using his idea that a person's stock/bond allocation should be between 75-25 and 25-75, my idea is that my asset allocation will be based on a comparison of the S&P 500's "earnings yield" to AA bond yield. Here are my proposed allocations:

Earnings yield at more than 120% of bond yield = 75% stocks
Earnings yield at 110%-120% of bond yield = 65% stocks
Earnings yield at 100%-110% of bond yield = 55% stocks
Earnings yield at 90-100% of bond yield = 45% stocks
Earnings yield at 80-90% of bond yield = 35% stocks
Earnings yield at less than 80% of bond yield = 25% stocks
In "Valuing Wall Street", chapter 24 "Yield Ratios and Yield Differences" is devoted to examining the comparison of earnings and dividend yields with bond yields as a measure of stock-market value. They fail all four tests the authors apply to different valuation methods. To paraphrase various section headings in that chapter: they do not provide a measurable indicator of value, they do not mean-revert, they do not make economic sense, and they do not tell you anything about future share values.

I strongly support your idea of taking into account valuations, but suggest you read "Valuing Wall Street" then develop a strategy based on using "q" or PE10.
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jar2574
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Re: Personal Asset Allocation Based on Graham Rather than Ag

Post by jar2574 »

cjking wrote:
jar2574 wrote: The "earnings/price ratio" is often called "earnings yield." Using Graham's quote as a guide, and using his idea that a person's stock/bond allocation should be between 75-25 and 25-75, my idea is that my asset allocation will be based on a comparison of the S&P 500's "earnings yield" to AA bond yield. Here are my proposed allocations:

Earnings yield at more than 120% of bond yield = 75% stocks
Earnings yield at 110%-120% of bond yield = 65% stocks
Earnings yield at 100%-110% of bond yield = 55% stocks
Earnings yield at 90-100% of bond yield = 45% stocks
Earnings yield at 80-90% of bond yield = 35% stocks
Earnings yield at less than 80% of bond yield = 25% stocks
In "Valuing Wall Street", chapter 24 "Yield Ratios and Yield Differences" is devoted to examining the comparison of earnings and dividend yields with bond yields as a measure of stock-market value. They fail all four tests the authors apply to different valuation methods. To paraphrase various section headings in that chapter: they do not provide a measurable indicator of value, they do not mean-revert, they do not make economic sense, and they do not tell you anything about future share values.

I strongly support your idea of taking into account valuations, but suggest you read "Valuing Wall Street" then develop a strategy based on using "q" or PE10.

That sounds like an excellent book, thank you for the advice. I am googling, and may need to order it from Amazon.

Do you know offhand whether using the earnings yield of PE10 would change any of the results of those four tests? I can understand how one year's earnings yield could be too volatile to be a good predictor. I am wondering if using earnings yield of PE 10 would solve that problem. Thanks again.
cjking
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Post by cjking »

saurabhec wrote:I think things like P/E 10 are handy to get a helicopter view of valuations, but as a market timing tool, I would not rely on it. If such a simple pattern were to be highly reliable and predictive, then it would get arbitraged away and cease to exist at some point in the future.
There's no "if" about how well it works as a predictor of something. That something is what Bogle calls fundamental value. The only fly in the ointment is that there is a random component which he calls speculative value laid on top of that at any given time. So the predictor tells you the average return you can expect to exit your holding on over a long range of future dates, but not much about what the actual value will be during any give shorter period your exit date might fall in.

The reason it is not a market-timing tool and doesn't appear to get arbitraged away appears to be because it's predictions work on a longer time scale. If lots of people did start using it as an indicator, all that should mean for a valuation-based strategy is that the stock-market would become more predictable while delivering the same return, switching triggers would no longer fire, and the strategy would degenerate into buy-and-hold. i.e. there's no reason why a sensible valuation based strategy would do worse than buy-and-hold, even if in the future, unlike the past, valuations were constant. (I guess by "sensible" valuation-based strategy I'm being tautalogical, a "sensible" one is by definition one that would degenerate gracefully as described.)

I watched the Swensen lecture at "Academic Earth" this morning, and in the questions at the end, he was asked whether changing his asset allocations according to valuation level was market timing. He said that he didn't see it that way. He regarded market timing as more short-term than that.
Last edited by cjking on Wed Apr 29, 2009 12:03 pm, edited 1 time in total.
saurabhec
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Re: Personal Asset Allocation Based on Graham Rather than Ag

Post by saurabhec »

Valuethinker wrote:
I should add you should read the Andrew Lo paper about the summer of 2008 (August 7th I believe).

Hedge Funds read the same academic papers we do. A hedge fund went into forced liquidation in that period, and the impact on value stocks was dramatic, and painful.
Excellent advice in the other post but a couple of minor quibbles:

1) Latest edition of Siegels book says that Price/Dividend and Price/Earnings were both pretty close to Price/Book in explanatory power in the original FF paper data set. He cited some unpublished paper to claim that in the post-FF period, Price/Dividends and Price/Earnings was slightly better (it was unclear whether the unpublished paper came from FF or himeslf).

2) Many prominent experts (most notably William Bernstein) are on record saying that risk does not explain the value premium and behavioral reasons are probably a big part of the story. If risk is the major part, then this recession is where value should have underperformed by a country mile. It simply did not, even if you look at the worst part of the bear from Sept-15 (post Lehman) to mid-Nov low: the S&P 500 was down around 37%, and the Vanguard Mid-cap Value Index was down about 44%.
cjking
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Re: Personal Asset Allocation Based on Graham Rather than Ag

Post by cjking »

jar2574 wrote: Do you know offhand whether using the earnings yield of PE10 would change any of the results of those four tests? I can understand how one year's earnings yield could be too volatile to be a good predictor. I am wondering if using earnings yield of PE 10 would solve that problem. Thanks again.
The short answer is that the earnings yield of PE10 works very well as a predictor. See my reply to somone else about what it predicts though. It predicts the long-term trend very well, but the stock-market can wander far away from its long-term trend for a period as long as a decade or two, so your strategy needs to incorporate that.

The slightly longer answer is that that whole book advocates another measure, "q", however they show that CAPE (cyclically adjusted PE, i.e. PE10) works just as well, and is only inferior in theory, because there is no economic explanation of why it should mean revert. The book does contain a proof that CAPE is equivalent to "q" as a valuation measure, so you can say that PE10 must mean-revert because "q" does.

In practise, it is easier to get information for PE10 than "q" off the web.

Edit: I've just looked it up, and the results were a little more skeptical than I remembered. In summary, for CAPE, they said it is not always measurable, it does mean-revert, it makes economic sense provided you assume the stock-market is going to yield the same in future as it has done in the past, and it would say something about future returns, if you could measure it.

So the root of their objection seem to be that it isn't measurable. I think this is because the cyclical adjustment is imperfect, because you don't know future earnings. I think they then go on to say that if you do the cyclical adjustment in the right way, then it is measurable, but then becomes synonomous with "q", as a measure of value. I'm just gleaning random fragments from the book here - I think you'd better read it for yourself and get the full story.

Edit 2: Despite the skepticism, their own charts show that historically CAPE has most of the time agreed with "q", so it can't be that bad. Here is a link to a chart from one of the author's web site showing a long-term history of both valuation measures.

http://www.smithers.co.uk/page.php?id=34
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jar2574
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Post by jar2574 »

FWIW:

Using the method I outlined above, adjusted to earnings yield based on PE10, today would have been a day that triggered a reallocation. An investor would have moved from 75% stocks to 65% stocks.

Shiller's PE10 was listed at 15.24 at close today, which would give an earnings yield of 6.56%.

The AA bond rate is 5.49% according to WSJ's website.

The PE10 earnings yield is therefore at 119% of bond yield, and would trigger an adjustment.

---

Now if/when I actually adopt this plan or another like it, I plan on just checking the math once a month. I'm not going to adjust everyday. I check my portfolio about once a month anyway, so it wouldn't increase my workload.

---

I need to doublecheck the figures I did at home, but I think that an investor using this method would have been 25% stocks from 1993 - 2008, and would have then gone to 75% stocks fairly abruptly, with only a couple months at allocations between 25% and 75%. And now he'd be down to 65%.

I need to go back father than 1993, but that's as far as I've gotten.

I used federal reserve tables on AAA bonds and the Shiller data on PE10. I'd prefer AA bond data, but haven't located any. The AAA bond info seems pretty close.
freedomfunds
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Location: Los Angeles,CA

Post by freedomfunds »

Using p/e's are great. Best buys are the VGK, European Market Index , 500 Index, SPY, and VPL, Pacific Asia.
Index choice matters. | | Valuations matter even more.
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jar2574
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Post by jar2574 »

cjking --

I bought that book on Amazon. (used)

Hopefully earnings yield of PE10 will work because reading reviews and google results makes it look as though "q" is basically impossible for a layperson to calculate.
peter71
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Post by peter71 »

Just looked at this thread for the first time and haven't really read it, but you asked for papers and it doesn't look like this one has been posted and it seems closely related to your suggestion in the OP:

http://papers.ssrn.com/sol3/papers.cfm? ... _id=445920

Abstract:
In this paper, we present a few simple market-timing strategies that appear to outperform the "buy-and-hold" strategy, with real-time data from 1970 to 2000. Our focus is on spreads between the E/P ratio of the S&P 500 index and interest rates. Extremely low spreads, as compared to their historical ranges, appear to predict higher frequencies of subsequent market downturns in monthly data. We construct "horse races" between switching strategies based on extremely low spreads and the market index. Switching strategies call for investing in the stock market index unless spreads are lower than predefined thresholds. We find that switching strategies outperformed the market index in the sense that they provide higher mean returns and lower variances. In particular, the strategy based on the spread between the E/P ratio and a short-term interest rate comfortably and robustly beat the market index even when transaction costs are incorporated.

All best,
Pete
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jar2574
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Post by jar2574 »

peter71 wrote:Just looked at this thread for the first time and haven't really read it, but you asked for papers and it doesn't look like this one has been posted and it seems closely related to your suggestion in the OP:

http://papers.ssrn.com/sol3/papers.cfm? ... _id=445920

Abstract:
In this paper, we present a few simple market-timing strategies that appear to outperform the "buy-and-hold" strategy, with real-time data from 1970 to 2000. Our focus is on spreads between the E/P ratio of the S&P 500 index and interest rates. Extremely low spreads, as compared to their historical ranges, appear to predict higher frequencies of subsequent market downturns in monthly data. We construct "horse races" between switching strategies based on extremely low spreads and the market index. Switching strategies call for investing in the stock market index unless spreads are lower than predefined thresholds. We find that switching strategies outperformed the market index in the sense that they provide higher mean returns and lower variances. In particular, the strategy based on the spread between the E/P ratio and a short-term interest rate comfortably and robustly beat the market index even when transaction costs are incorporated.

All best,
Pete
That paper looks like exactly what I was looking for. Thanks Pete!
maxwellthedog
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Post by maxwellthedog »

Part of the advantage of PE10 is that it does not rely on forward earnings estimates. By converting earnings to real earnings (adjusting for inflation) and then taking a 10 year average, you are adjusting for more abrupt swings in economic growth (index earnings). Over the long run, real economic growth is about 2-3%, so by looking at recent earnings relative to the 10yr average, you can get a sense of whether the economy is earning above trend or below trend. For example, from Shiller's website, the 10yr average real earnings is about $57 for the S&P 500. But in late 2007, earnings peaked at about $86. The signal from this data was that while the real P/E ratio was relatively high at 27, it was also on top of a rate of earnings that was more than 50% higher than what you would expect from a trend rate of growth.

The point is that this system actually gives you two signals-- one on the PE, or relative valuation of stocks to underlying trend rate of growth, and one on the rate of growth of the economy relative to a long-run trend.

For comparison's sake, in March, we were at a PE10 ratio of 13 and earnings were about $18 (against a trend rate of $57). So earnings are below trend and the PE is below its long-run average of 16 (though not terribly so).

Like I said before, this is not an exact science. You could come up with a long list of reasons why current valuations and earnings rates are going to be off-trend for a long time. But when I am buying equities, I want to tilt the odds in my favor as much as I can that I am buying at a reasonable price, and I think this helps.

As for how much I tilt, it seems like +/-15% probably makes some sense. Our normal allocation to equities is 50% (I work in finance so I already have a lot of equity risk in my life). Right now, our allocation is over 60% (but not much). In a defensive mode, I would want to be under 40%. I would not go to 0% or 100% because this method is not foolproof.

This is shading, not whipping it around...
cjking
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Post by cjking »

One rule of thumb I've derived from Shillers data, with the help of Excel Solver, is: if PE10 is in the range 8 to 20, expect a real return going forward of 0.9/PE10. (The actual figure solver came up with was 0.884/PE10, but 0.9 is more memorable.) The rule has been very accurate within that range. Outside that range, actual returns have been lower than that rule would predict, but obviously still very good when PE10 was less than 8, and poor when more than 20.

What the rule predicts is 40 year hindsight value. This is a concept defined in "Valuing Wall Street." It is the average annual return experienced by a cohort of 40 investors from the prediction date forward, where the first investor sells after one year, the second after two, and so on up to 40. This averaging process eliminates "speculative return" from the prediction target.

In real life you will probably want to sell on a particular date, not an average of 40, so your strategy still needs to deal with the possibility that the stock-market will be some distance from fundamental value when you want to sell.
kencc
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Post by kencc »

jar2574 wrote:But for the sake of this discussion, please assume that I have a very high risk tolerance and plenty of capital to stick with the plan.
It appears unclear as to your overall objective in such a proposal. For example, is there a fixed stock/bond ratio that you would consider as a benchmark and would you anticipate obtaining returns better than that? Or is your objective to avoid large drawdowns such as during the current bear market? Personally I doubt that a very high risk tolerance or plenty of capital would be relevant factors - probably the greatest requirement would be considerable patience when the strategy under-performs B&H for extended periods of time.

(Disclosure: I am a Graham-type 75/25 to 25/75 Defensive Investor but use price action rather than valuations to change allocations)
kencc
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Post by kencc »

linuxizer wrote:I believe that Bogle has stated he is fine with up to 15% "tactical asset allocation" in either direction, so 30% total (someone correct me if I'm wrong here). This forum tends to discount that philosophy, but in the end it probably doesn't matter too much (although 30% is quite a bit).
Mr Bogle accepts a "moderate amount" of Tactical Asset Allocation as in Common Sense on Mutual Funds :-
It does not abandon the "stay the course" principle, but it allows for a mid-course correction if stormy weather threatens on the horizon. If rational forecasts indicate that one asset class offers a considerably better investment opportunity than another, you might shift a modest percentage of your assets from the class judged less attractive to the class judged more attractive. This policy is referred to as tactical asset allocation.......

..... if your optimal strategic allocation is 65 percent stocks, limit any change to no more than 15 percentage points (50 to 80 percent stocks), and implement the change gradually.....

What might dictate moderate shifts in tactical asset allocation? One example: concern that stocks are substantially overvalued relative to bonds..... If you have 65 percent of your portfolio in equities, retain at least 50 percent; if 50 percent, at least 35 percent, and so on. A little caution may represent simple prudence, and, if you are relatively risk-adverse, may enable you to sleep better, a blessing that is hardly trivial.
Therefore if one has a basic 50/50 allocation then that could change between stocks/bonds 65/35 to 35/65, i.e nearly 50% of stocks would be gradually sold off to make that change - I've always doubted that this could be described as a "moderate" shift in tactical asset allocation. A Graham-type defensive investor, making infrequent and gradual changes between 75/25 to 25/75 is not too dissimilar in magnitude.
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jar2574
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Post by jar2574 »

kencc wrote:
jar2574 wrote:But for the sake of this discussion, please assume that I have a very high risk tolerance and plenty of capital to stick with the plan.
It appears unclear as to your overall objective in such a proposal. For example, is there a fixed stock/bond ratio that you would consider as a benchmark and would you anticipate obtaining returns better than that? Or is your objective to avoid large drawdowns such as during the current bear market? Personally I doubt that a very high risk tolerance or plenty of capital would be relevant factors - probably the greatest requirement would be considerable patience when the strategy under-performs B&H for extended periods of time.

(Disclosure: I am a Graham-type 75/25 to 25/75 Defensive Investor but use price action rather than valuations to change allocations)


The overall goal of this strategy would be to purchase assets as a defensive investor -- taking prices into account to ensure adequate returns and safety of principal.

I think your analysis of the most relevant factor for using this strategy is spot on. Patience with underperformance would be the key.

I only mentioned the other factors to preclude their discussion. Other threads deal with risk tolerance and capital requirements.

Because patience with underperformance is the potential weak link, and because I have not had the opportunity to prove that I have that patience, I am debating my rebalancing strategy.

If I make future contributions based on these figures, I could be confident that I bought more stocks when they were cheap relative to bonds and bought fewer stocks when they were expensive relative to bonds. I don't know if I need/want to rebalance.

I would have been purchasing 25-75 stocks/bonds from at least 1993 - 2007, and probably much longer. (Still need to work on pre-1993 numbers.) By not rebalancing, stocks would have probably reached 50% or more of my portfolio. I'm not sure I would have wanted or needed to rebalance, as long as I knew that most contributions were going to bonds.

So in other words, I am thinking that it would be good to rebalance as the market travelled up or down the bands. But once I reached the outer limits, I am not sure that I would have the guts to continually rebalance towards 75% stocks in a bear, or the patience to continually rebalance towards 75% bonds in a bull. It might have to be enough to simply buy at those rates and let the market take its course.

I have more data to crunch this weekend.
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CyberBob
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Post by CyberBob »

Well rather than changing allocations in 5 or 10% chunks or whatever, I would assume allocations should be done to bring the stock and bond values into parity. That is, 50/50 when the earnings yield and bond yield are identical, and allocations adjusted according to how far apart they are when they're not equal, subject to Graham's 75% maximum, 25% minimum.

Allocating once a year, based on the December 31st earnings yield and bond yields (of the Total Stock and Total Bond index funds) would have given you these allocations over the last 13.5 years (all the data I had readily available):
Image

The allocation is, I think, quite interesting. It seems that as the market got more expensive in the late 90's, the bond allocation drifted higher. And, during the 2000-2002 bear market, you would have been about 2/3 in bonds, which wouldn't have been hard to take at all. The next few years would have been pretty close to the standard 50/50 until after the big 2008 downturn at which time you would have gone 2/3 into stocks, just in time to ride the gain in 2009.

And, looking at the graph below, the Graham method would have given you a return over the period that was higher than any static combination of stocks and bonds, as well as having a lower standard deviation than the static 50/50 portfolio. (graph shows growth of $100k initial investment)
Image

Graham was a pretty swift guy, and, all in all, it seems like a great way to tilt a bit towards the currently 'undervalued' asset class while, in general, maintaining a nicely conservative portfolio. I like it! :)

Bob

P.S. pardon my necromancing of an old thread, but I have been playing around with some nifty spreadsheet graphs since I've recently been re-reading some of Graham's works.
daydreamin
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Post by daydreamin »

CyberBob wrote: Allocating once a year, based on the December 31st earnings yield and bond yields (of the Total Stock and Total Bond index funds) would have given you these allocations over the last 13.5 years (all the data I had readily available):
Very cool stuff. Sorry for being slow, but can you explain exactly how you calculated these allocations?

Where do you find the earnings yield for the Total Stock index? And then what formula do you use to get what the stock/bond allocation should be?

Thanks!
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CyberBob
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Post by CyberBob »

daydreamin wrote:Where do you find the earnings yield for the Total Stock index? And then what formula do you use to get what the stock/bond allocation should be?
You can find the P/E (Price/Earnings) ratio on the fund page on Vanguard's website (or in the annual reports). The earnings yield is just 1 divided by the P/E. For example, for a P/E of 17 you would have 1/17=0.0588 or a 5.88% earnings yield.

As for figuring the percentages, you just want to make the allocations equal based on the differences between earnings yield or bond yield. For example, using the number above, if the earnings yield for stocks was 5.88% and the bond yield was also 5.88%, then the allocation would be 50/50. Stock earnings yield * bond % = bond yield * stock %

But if they are different, say, using the numbers for 2006, you would have an earnings yield of 5.41% and a bond yield of 4.75% meaning that you would again want this to be true:
Stock earnings yield * bond % = bond yield * stock %
And since bond % + stock % = 100, or to rearrange it another way bond % = 100 - stock %, you get:
stock earnings yield * (100 - stock %) = bond yield * stock %

So using the 2006 numbers as an example, you can just solve the equation:
stock earnings yield * (100 - stock %) = bond yield * stock %
5.41 (100 - stock %) = 4.75 stock %
(100 - stock %) = 0.878 stock %
100 = 0.878 stock % + stock %
100 = 1.878 stock %
stock % = 100/1.878
stock % = 53.2 %

bond % = 100 - 53.2 %
bond % = 46.8

It's actually much simpler than my confusing algebra example makes it seem :D
To make it even easier, you can always use the goal seek or solver function in your spreadsheet.

Bob
daydreamin
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Post by daydreamin »

Great, thanks. So using the current numbers from Vanguard's website:

VTWSX PE = 21.2, earnings yield = 4.71%
VBMFX yield = 2.94%

The VBMFX yield is the SEC yield from the Vanguard website. There's also the "yield to maturity" (3.3%), the yield from Google finance (4.55%), and the yield from Yahoo finance (3.77%). Not sure which one I should use, but using the SEC yield I get:

4.71 * (100 - stock) = 2.94 * stock
471 - 4.71stock = 2.94stock
471 = 7.65stock

stock allocation = 61.5%, bond allocation = 38.5%

Is that right? Looking at your chart, that implies we're in a time when stocks are significantly better to buy than bonds. The only time in the past ten years when this formula would have recommended a higher allocation to stocks was 2009.

Interesting stuff. Thanks for sharing!
TimDex
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Graham

Post by TimDex »

Bob -- You may have seen it, but if you haven't, Jason Zweig has posted a "lost" speech of Graham's at:

http://www.jasonzweig.com/grahamspeech.html

A lot of what Graham advocates are ways for investors not to defeat themselves; he pretty explicitly advocates what amounts to an index approach, and this in 1963, when such an animal didn't exist.

He also discusses his approach to valuing the market.

Tim

(Note: The speech is not text, but pdf's of a typewritten text, with a very funky hand drawn cover. Takes a while to download and print out.)
Last edited by TimDex on Thu Jun 03, 2010 8:31 am, edited 1 time in total.
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