Using Asset Allocation To Manage Risk Tolerance

November 17, 2009

Asset allocation can protect investors from impulsive behavior by giving them a guide to maintain the proper balance in volatile markets.

 

A new client recently expressed his frustration by telling me, “If you want to get rich trading the stock market, just watch what I do and then do the exact opposite.”

In March, very close to the low of the year, he had liquidated most of his stock portfolio and stood on the sidelines as the market rallied back by more than 50 percent. I sympathized with him and pointed out that he had a lot of company, because March was when investor anxiety peaked, causing more than a few investors to cash out.

KentGrealish_ColumnAnd while it is now crystal clear that selling around that time was not a wise decision, human nature certainly made it feel like it was the right thing to do at the time. The more you had invested in the market, the greater the compulsion to sell.

The temptation to sell low (after buying high) is strongest when we have taken on too much risk. Being overinvested as the market goes into free fall intensifies our sensitivity to loss and brings us to the limits of our risk tolerance. Once that risk tolerance is violated, emotion takes over as the primary decision-maker.

Riding out a bear market has been compared to being “sandpapered to death”: Initially the experience is more irritating than painful. But after a few levels of epidermis have been removed, the slightest touch can cause excruciating pain. This is why risk tolerance is sometimes described as the threshold of pain—the tipping point where attitude can shift suddenly and dramatically.

We need tools to keep us from crossing that threshold and triggering an emotional investment decision. This is where asset allocation comes in. Using even a relatively simple asset allocation plan can help manage personal risk tolerance during volatile markets. This can work on two levels.

Initially a good asset allocation strategy will help establish the right level of risk and avoid the temptation to time the market. Most investors realize that they shouldn’t take on too much risk but neither should they take too little risk, since that produces substandard returns.

A prudent asset allocation policy can address that dilemma by reining in the speculator to keep him from overweighting or by forcing the timid investor to step up to the plate, preventing him from underweighting out of undue caution.

Secondly, a good asset allocation strategy satisfies the first rule of investing: “Buy low, sell high.” When you rebalance, you are forced to sell the better-performing asset (which is now relatively high) and buy the poorer-performing asset (now relatively low).

A Thorn In Purists' Sides?

The fact that this deals with relative rather than absolute values may bother some purists, but this technique focuses more on simplification and avoiding the risk of emotion creeping in disguised as a value judgment. It seems to me that the more mechanical the process, the more likely that it will actually be implemented.

Proper rebalancing is a crucial component of every asset allocation plan. How often you should rebalance is a matter of opinion, but nearly everyone agrees that you should rebalance periodically to bring the asset mix back to the target ratio. While it is essential to set a regular rebalancing schedule, it is equally important to establish limits to constrain how far the allocation can get out of proportion before rebalancing is necessary.

Setting high and low limits also determines your decision points. It answers the question: “Should I do anything now that the market has moved 500 points?” As long as the allocations stay within the constraints, you simply stick with the plan and avoid making what would be a reactive decision. If a limit is violated, you know you need to rebalance. This helps eliminate both indecision and procrastination and should also provide greater peace of mind.

Like indexing, asset allocation can protect us from impulsive behavior by establishing an initial asset mix and by giving us a guide to maintain the proper balance in volatile markets.

If we ignore the element of human nature, we elevate the theoretical above the practical. The biggest waste of money and energy is designing an elegant investment plan with a high probability of success that ends up being abandoned in the depths of a bear market. A long-term plan is worthless if the investor can’t live with it in the short run.


Kent Grealish is a partner at Quacera Capital Management, a fee-only advisory firm. He welcomes comments and suggestions for future columns at:

[email protected]

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