Typical advice for investor portfolios is to choose some asset allocation such as 50% stock and 50% bonds, and rebalance as necessary to maintain this balance. As Larry MacDonald reported, PŮR Investing Inc. offers a different approach that focuses on risk (full description here). Their approach actually combines two strategies that are sometimes at odds.
PŮR is critical of typical target date funds that slowly reduce portfolio risk on a fixed schedule as the target retirement date nears. PŮR proposes two strategies:
1. Rebalance individual portfolios to maintain a fixed level of risk rather than a fixed percentage asset allocation.
2. Choose a level of risk over time designed to get the portfolio to a target dollar amount.
The first strategy involves selling out of investments when volatility increases. So, when stock prices start to jump around, shift money to bonds to maintain a fixed risk level, and when stock prices becomes less volatile, shift back.
The second strategy involves choosing a level of risk that maximizes the chances of building the portfolio to a target amount by the investor’s retirement date. PŮR describes this idea delicately by saying that as the portfolio builds close to the target amount, money is shifted to safer investments. This sounds much better than saying that when the portfolio value drops, start taking bigger chances to try to make the money back.
When we think about these strategies in isolation, they tend to sound quite smart. Get out of stocks when they become risky, and buy more stocks when the price is low. But, what do you do if stock prices become more volatile at the same time that they have dropped in value? The two strategies will offset, and minimal action will be taken.
I'm convinced that the second strategy makes sense; investors have little choice but to take some chances to reach a minimum standard of living for retirement. The first idea about maintaining constant risk is intriguing, but I’m still mulling it over. It’s not clear to me whether it will give investors better results than standard asset allocation.