Tuesday, August 2, 2016

Is Your Allocation to Stocks Too High?

I recall many articles advising investors to reconsider their appetite for risk in the aftermath of the 2008-2009 stock market crash. However, today is a much better time to do this.

After the crash, “experts” said that while it’s foolish to sell stocks when they’re cheap, reducing your percentage stock allocation to a more comfortable level is smart. This is nonsense, of course. Selling low is dumb whether you have a smart-sounding reason or not.

It’s impossible to say exactly when stocks are too expensive or not, but it seems safe to say that they’re not very cheap right now. This makes now a good time to think about whether you’re taking on too much risk. Try to remember how you felt back in 2008-2009. How would you feel if that happened again?

Personally, I have no intention of reducing my allocation to stocks, but now is a much better time to do this than it was 7 years ago. Sadly, though, individual investors are more likely to decide to increase their allocation to stocks today than they were 7 years ago.

18 comments:

  1. It's a good time to let cash build up in the portfolio for the future re-balancing when equities are cheaper.

    Price is What You Pay, Value is What You Get
    Warren Buffett once said that as an investor it is wise to be “Fearful when others are greedy and greedy when others are fearful.”

    ReplyDelete
    Replies
    1. @Anonymous: I have no idea if stocks will ever be cheaper in the future. I'm not a fan of holding cash because I can't identify under-priced stocks the way Buffett used to. But I think now is a good time to decide whether your long-term risk level is too high.

      Delete
    2. "It’s impossible to say exactly when stocks are too expensive or not, but it seems safe to say that they’re not very cheap right now. This makes now a good time to think about whether you’re taking on too much risk."

      Why is now a good time to "think about...risk"?

      More simply...how do you measure or define risk?

      Delete
    3. @Anonymous: Risk is higher when prices are higher. It makes more sense to think about reducing risk when prices are high than when prices are low. There is nothing special about now other than it not being a time immediately after a stock crash.

      I'm using risk here to mean the possibility of losing money or at least making less than you plan for over the long term. Substitute a different term if you like.

      Delete
  2. This is a great point. It's only natural to feel like reducing allocation when stocks are down, but by then it's often too late: everyone has already shunned stocks by then.

    I'm reminded of a post you made saying even if stocks are overvalued, they can gradually rise more slowly than earnings growth until fair value is reached.

    ReplyDelete
    Replies
    1. @Gene: The other side of this is that almost nobody feels like reducing their stock allocation right now. Not that I'm recommending this to anyone. What I'm focused on is when it makes sense to evaluate whether a permanent drop in stock allocation is appropriate.

      Delete
    2. I like that: if you want to change your allocation, don't do it often, or that's market timing. Think of the change as permanent. Also, I think it was Ben Graham who said don't sell after a significant drop and vice versa: don't buy after a large rise in prices.

      Delete
    3. @Gene: So, my adaptation of Graham's words would be don't make a permanent reduction in stock allocation after a big drop in stocks prices, and don't make a permanent increase in stock allocation after a big rise in stock prices.

      Delete
  3. It's being countercyclical. What happens when stocks reach high valuations is that more of your portfolio risk is derived from the stock portion (assuming a <100% stock portfolio). Reducing equity exposure at high valuations is basically about rebalancing risk.

    Of course, if you hold 100% stocks, there is no escaping the increased risk.

    ReplyDelete
    Replies
    1. @SST: Rebalancing is an important topic, but not one I intended to discuss here. Even for investors who choose fixed percentage allocations and rebalance regularly to maintain these percentages, it's natural to re-evaluate whether their percentage targets are appropriate. After the 2008-2009 crash, many bloggers advocated considering a reduced percentage allocation to stocks. I think now is a much better time to examine whether investors should be taking less risk with stocks.

      Delete
  4. And what do you do with cash once you sell stocks? Buy bonds which pay less than inflation in the hope that interest rates go negative?

    ReplyDelete
    Replies
    1. @BHCh: I guess there are many choices including bonds, cash, GICs, and real estate. These aren't choices I'd make, but for someone who doubts his ability to stay calm through stock market gyrations, it's better to make little on fixed income than it is to sell out of stocks in a panic for a huge loss after the next crash.

      Delete
  5. With stocks not being "cheap", should people also re-evaluate their actual cash inflow allocation between retirement savings and "good" debt repayment (mortgage and tax-deductible student loans)?

    ReplyDelete
    Replies
    1. @Ferd: Now is a better time to consider paying off loans more aggressively than it was 7 years ago when stocks got clobbered. Whether to actually make any permanent changes to a personal plan is an individual choice.

      Delete
    2. Thanks! Do you have any other way to think about how much to pay down, other then comparing interest rates on loans vs. "expected returns" on stocks?

      Delete
    3. @Ferd: I tend to think about whether I'd be okay in temporary bad scenarios. So, what if stocks drop 20% and you lose your job? If that prospect makes you tremble, then maybe you should build up more emergency savings and pay down debt a little more aggressively. I think this type of analysis needs to be taken care of first before you make finer optimizations concerning long-term returns.

      Delete
  6. Cash can be a good thing as well in a long-term retirement portfolio.
    https://sothatshowyoudoit.wordpress.com/2016/04/02/the-effect-of-a-cash-buffer-on-returns/

    ReplyDelete
    Replies
    1. @Anonymous: I've said similar things in the past:

      http://www.michaeljamesonmoney.com/2014/02/cushioned-retirement-investing.html

      Delete