We received an excellent question from Graham regarding asset allocation and so I thought we would post the answer here as well. 

Hi Graham,

Thanks for the question and glad you are enjoying the podcast.

Asset allocation and rebalancing are probably the toughest decisions and investor need to make. We see rebalancing as a subset of asset allocation. The central question is - how much should I have in the market now?

Asset allocation is also where investors make mistakes, mostly because they over-allocate or at times have too much money exposed when valuations are very high and too little when valuations are low. We think the reason why is because people get a little too greedy after the markets have a good run. They usually fall into the recency bias trap thinking markets will keep rising and so they fail to rebalance (by selling a portion). Markets fall at some point and they regret they didn’t rebalance.

Now to your question. There are two parts to the answer.

Use Valuations - we use CAPE and other metrics to give us a broad indication of ‘value’. The S&P is currently at 35 which is twice the long term average. Given we know markets fall a lot from these higher valuation, you may want to have less allocated to stocks. Of course, this is painful because if the market continues to rise, you get the feeling that you are missing out. But if you think long term, avoiding losses (and understand the maths of rebalancing) is much most important than trying to get the last 5%. That is why we constantly preach about not losing money rather than always trying to make a bundle.

The second part is the actual rebalancing. There are a few ways to do it, and no one way is superior because the market volatility is what really matters. Doing it systematically is the key.

So, the “how to” bit.

Look at CAPE - it’s at 35 and the long term average is 17, then maybe you should have a smaller allocation. So for example 50% of your total allocation. If you have $20,000 then make the allocation $10,000 and hold the cash until the market and CAPE decline to more reasonable levels.

Alternatively, you can combine the CAPE with a technical indicator like the 200 simple moving average. Here, you might stay fully invested until the market hits the 200 SMA on the way down and then rebalance back to a figure you are comfortable with. The tricky bit here is the market bounces and returns higher.

The art of investing is always getting the allocation right, but the core point is not losing money and that means taking profits in a systematic way. Hence the reason why we teach the 8 principles. It allows us to invest over the whole cycle and not be swayed by our emotions.

I hope that helps.