The Sapient Investor

Most of the return from a diversified portfolio is derived from stock market exposure. If an investor can increase or decrease exposure to the stock market at the right time, he or she can avoid much downside loss and gain much upside return. There is more reason to believe that asset classes are inefficiently priced relative to each other than that individual assets are mispriced within asset classes. If that is true, then tactical asset allocation, if done well, can be extremely beneficial.

Measuring risk is the first step in controlling risk. In a diversified portfolio, most risk is systematic risk, since a lot of the non-systematic risk is diversified away. Systematic risk is explained by one or more risk factors such as stock market risk or interest rate risk. My research suggests that four risk factors will capture most of the risk in most portfolios.

Real estate is a huge part of the global capital market, but most portfolios have little exposure. Many investors have an undiversified investment in residential real estate by owning a home, but REITs provide a convenient way of gaining broad exposure to many types of commercial real estate. They also help diversify a portfolio’s stock market risk.

Next to the stocks vs bonds allocation, the U.S. vs international stocks decision is the most important for most portfolios. Unlike the 60/40 traditional stocks/bonds mix, there is no well-recognized default position for this choice. I recommend a middle path between two extreme views, with significant flexibility in tactically implementing around the long-term strategic allocation target.

Although they are often excellent diversifiers of equity market risks, government bonds are not likely to be good investments going forward. Their yields are low (or in some cases, negative!). The marginal buyers for government bonds are often motivated by considerations other than risk and return. This keeps their prices structurally above the levels that would make them attractive to most investors.

Most people intuitively understand the appeal of diversification—spreading your risks around so that if something goes wrong in one investment hopefully some others will be doing well. It has to do with the old saying, “don’t put all your eggs in one basket.” But how do you measure diversification? And how much difference does it make in portfolio returns and ending wealth?

The single most important decision in managing a bond portfolio is deciding how much interest rate risk to accept. In an earlier article I introduced the concept of using current market conditions to tactically rebalance around a long-term strategic asset mix. This methodology I call the “Dynamic Model.” This article will apply the same concept to tactically managing the interest rate risk in a bond portfolio and present some back-test results using that approach.

In an earlier article I introduced the concept of using current market conditions to tactically rebalance between stocks and bonds around a long-term strategic asset mix. This methodology I call the “Dynamic Model” approach to managing the asset mix. In this article, I will explain the model’s methodology and compare its' back-tested performance to a static 60/40 stock/bond asset mix.

Many investors assume that their strategic asset mix is somehow sacrosanct. They have been told that they should rebalance back to the strategic targets if their portfolio gets out of whack. This is despite the fact that the quality of the analysis behind the setting of the strategic asset allocation is usually subjective and often quite weak. I believe that using current fundamentals to estimate expected returns of stocks and bonds should guide the tactical rebalancing around the strategic targets.