Thursday, December 11, 2008

Static v. Dynamic Asset Allocation

Without putting a label on it until recently, I have been a practitioner of dynamic asset allocation my entire life.

A static asset allocation does allow for changes in allocation percentages based on age and risk tolerance and a few other criteria. Static allocation also emphasizes diversification of asset classes and to spread investments over asset classes that have low correlations with one another. Periodic re-balancing among asset classes is also a requirement to bring percentage back to the original static allocation. A simple discussion of static asset allocation theory can be found in the recently released little book by David Darst called the "The Little Book that Saves Your Assets". This is a good book for beginners or anyone who has never thought about asset allocation or practiced it.  

In my view, the advocates for static asset allocation have yet to explain to me how it makes a meaningful and positive contribution to my net worth in periods like 1966-1982, or 2000 to the present, or from 1929 to 1940. It can work in other periods, like 1982 to 2000. The static allocation theory says start with a fix allocation to stocks, bonds and other asset classes.

As one becomes older,  exposure to riskier assets is reduced. So, in your 30s, stocks, foreign and domestic, would be heavily weighted whereas bonds would become a larger position when you are my age. Some asset classes would be added to the mix that have low correlations to the movement of other classes. And for a fully developed static asset model, there would be sub-classes within a class, like emerging markets in the foreign stock class or corporate or international bonds within the bond class. At certain intervals, a class that has risen above its assigned weight would be trimmed and the proceeds used to buy securities in a class that has fallen in value, thereby re-establishing the desired percentages among asset classes.

As I said, this would be fine for a market when major asset classes are in a secular bull market.  In 1987, some stocks would be sold and some bonds would be added and this would have helped if done before the crash in October, for example.

The same would be true for the major rallies in stocks in the 1997 to 2000 period, when some of the stock market gains would be harvested and the proceeds applied to increase other asset classes. A static model might look something like this for a person with modest risk tolerance saving for retirement and 50 years of age: 60% in stocks, 25% bonds, 15% in all other asset classes (cash, gold, commodities, real estate, private equity, etc).

Within major classes like stocks, there would be percentages assign to subclasses so that stocks might have a 1/5th exposure to foreign stocks and within the foreign stocks class there would be a % for emerging market stocks). But the overall percentages assigned to each class are fixed initially, allowing for changes only with age or a major change in goals such as the near term need for cash soon to pay for college expenses, a new house etc.   

In dynamic asset allocation, the percentages also have to change based on circumstances independent of one's personal needs and objectives due to external events. In the period 1978 to 1982, I was a young man so my exposure to stocks would be fairly high under any static asset allocation model. I had almost no exposure with a 400 share lot of Duke being my only purchase between 1978 through June 1982.

Instead, I was investing mostly in short term debt instruments paying me over 10% and I did not lose a dime. Yields on short term bank CDs reached 15+% during that period. Around July 1982, I made a decision to start investing in stocks again and opened a brokerage account at Charles Schwab.

There was also back then a real estate bust. I looked around for a good lot for a home, found one that was over an acre in Brentwood and started to build a home. Besides having a place to live, I viewed the home as an investment that would appreciate tax free (or tax deferred) at a 4 to 5% compounded rate, so it was similar to buying a non-callable long term AAA municipal bond backed by U.S. treasuries since I did not borrow money to build it. It was an opportune time to invest in real estate coming out of a real estate recession. Construction workers were motivated to work and suppliers were just looking for a paying customer, and it was consequently a very inexpensive period to build a new home.

In other words, I did a major percentage asset shift from safe high yielding investments to real estate and stocks in the summer of 1982. I did not call it then a dynamic asset allocation model but that was exactly what I was doing. My regret was that I did not add some long term treasury bonds when the yield was 15%. I do not regret avoiding most stocks from 1969 to 1982 even though I was young and generally a frugal person who saved money rather than finding creative ways to spend it on stuff long since forgotten and disposed of.

I have discussed my VIX asset allocation model extensively in these blogs. This would be part of dynamic asset allocation model. It would cause a shift in stock allocation based on what was happening in the market rather than something peculiar to me like my age, needs, or risk tolerance. Other tools that I have used in dynamic asset allocation are to make significant reductions in any asset classes that was undergoing  parabolic upward moves, with the difficulty being to decide when to sell during the crazy period, and reductions/additions based on simple valuation criteria such as the market averages historical P/E ratios ( reduce stocks for example when the S & P 500 is selling at over a forward looking 18 P/E regardless of any other indicator, more if over 20 while adding back during bear markets by reinvesting dividends and deploying excess cash flow to buy stocks). Sometimes I might just rely on my opinion about cycles which was the case in causing a shift out of foreign currencies.

There can not be total reliance on any one tool that causes a shift in allocation percentages to different asset classes. I would also add that the dynamic asset model makes sense to me at least in the current period and in the period when I started to invest, which was between 1968 to 1982. 

I do not see how the static allocation approach would be much help to me during the past decade. At my age, I am of course reducing my stock exposure and would do so under both static and dynamic asset allocation models. Look back for the past decade, has static allocation increased your net worth in any meaningful way? Is that target asset allocation fund based on the year of retirement increasing significantly your assets available for retirement?  If you think that the static model is working over the past decade, I would suggest doing the calculations again. 

Speaking for myself, the static model is not a viable model during the past decade. Since I do not have that many decades left, a model that does not work for a decade is not a viable model.

Major shifts in asset allocation percentages have to occur based on events unconnected to me. Some would call that market timing and that charge may be correct. There is a market timing element to it. But some degree of market timing for asset allocation is needed in periods other than a long term secular bull market for major asset classes. For me, reductions in asset classes can still be based on factors advocated in the static allocation model such as my age and  periodic re-balancing by selling some in a winning asset class to buy more in one that has not kept up or even declined.

I still seek diversification and non-correlated asset classes. And, I will not do a huge shift out of an asset class like stocks anymore taking the allocation down to zero. Instead, I will reduce a sub-asset class- substantially-like treasury bills when their value skyrockets and the yields plunge as now and re-allocate that money to other investments like corporate bonds and CDs. For stocks I used some timing tools to sell last year making significant reductions to a stock allocation and building up cash. My allocation percentages are just not static for long periods of time and only adjusted for circumstances unique to me or periodic re-balancings .

The dynamic asset allocation model that I use is personal to me, my age and financial circumstances. The major difference in a dynamic model and the static one advocated by financial advisors is that significant shifts in percentages has occurred and will continue to happen based on external events that have nothing to do with me or my circumstances.

Disclaimer: I am not a financial advisor but an individual investor trying to navigate my way through a difficult market. In these posts, I am acting as an unpaid financial journalist and an occasional political commentator.  I am also aggregating financial news stories that I view as important and providing any reader of these posts, assuming there are more than a couple, with links to those articles, sort of a filtered, somewhat intelligent, free search engine.  Any discussion made by me of particular securities  is not a recommendation to buy or to sell.  Trade at your own risk.  Consult with your financial advisor prior to making any purchase or sale. I will try to identify my sales too but it may take a few minutes after I implement them to create a post explaining my reasons.  The sale may before or after the post.  Before buying or selling any stock, even one recommended by a trusted financial advisor,  please research it and make up your own mind which is what I always try to do.  Research would include reading reports, reviewing financial records, earnings estimates, sec filings and prior earnings releases and news.  In this post, and all others by me, I am merely describing my reasons for purchasing  or selling securities, and the potential pitfalls that I identified prior to purchase or the reasons for a sale.  The securities mentioned in this and all posts written by me may not be suitable for others based on their unique financial position and risk profile.  Always read the prospectus before buying a Trust Certificate, bond, preferred stock or other bond or bond like investments.  Information contained in my posts has been obtained from sources believed to be reliable but cannot be guaranteed.  These posts by me do not constitute investment advice, nor shall they be construed as a guarantee of future results, or as an offer of any transaction in securities.