“I think investment psychology is by far the more important element, followed by risk control, with the least important consideration being the question of where you buy and sell.” – Tom Basso
In a previous piece I spoke about value and momentum at the stock level, but today I am going to go over my first rule (There are 2) for my asset allocation decisions.
My base equity allocation is:
- 60% U.S. Stocks (Large-Cap Momentum 50% / Small-Cap Value 50%)
- 30% Foreign Developed ex-U.S. Stocks (Large-Cap Momentum 50% / Small-Cap Value 50%)
- 10% Emerging Markets Stocks (100% Large-Cap Value)
The first rule is related to the Equity Asset Allocations. I adjust the allocation to U.S. Stocks, Developed ex-U.S. Stocks and Emerging Stocks based upon long-term trends, or more precisely, relative long term return ratios (24 Month Moving Average Rule). The following is a screenshot of the data (1 of 3; the other 2 are at the end of the post) that I track in graphical form:
When the green line is above the orange line, U.S. Stocks are outperforming Foreign Developed ex-U.S. Stocks. When the opposite occurs, Foreign is outperforming U.S. Historically these periods of out-performance tend to occur over multi-year periods, i.e. They Trend.
I understand that this is not some perfect tool since nothing related to investing is. I also know that this is something that could stop working at any time and so because of that, there are ranges that these asset classes must remain in. U.S. Stocks will fluctuate between 50-70% of the Equity Allocation. Developed ex-US Stocks will fluctuate between 20-40% of the Equity Allocation. Emerging Stocks will fluctuate between 5-15% of the Equity Allocation.
Any changes made to the equity asset allocations are made at the beginning of the year (January) and cannot be updated outside of that, even if the lines cross mid-year. I put in this rule so that trading costs/events would remain low. From 1995-2016, this rule has caused 10 asset allocation changes, once every 2-2.5 years.
As an example of what this has looked like with just U.S. and Foreign Developed (U.S. and Foreign annual returns are derived from the Momentum/Value portfolios in a prior piece), take a look at the following table:
This strategy added about 1.10% per year over the last 22 years. Not too bad. More importantly though, it allows me to implement ideas that I believe in (Value and Momentum) at the asset level, while keeping me in check thanks to the range rules.
Here are the six possible allocations I could have in any given year:
My personal ranges keep me in check compared to the table above which started at 50/50 between U.S. and Foreign and could go as far as 75/25 in either direction. Because my ranges are not as wide (On purpose for behavioral reasons), I do not expect this to add 1+% annual long-term out-performance. My expectation in the long-run is that it will add around 0.50% per year, and yes, I know this could easily be 0% or even negative, but I think this strategy will continue to add some benefits over time.
One of the clear downsides of this relative return strategy is that you are inevitability overweight the more “expensive” asset class when things turn (Mid 90s, Late 90s/Early 2000s, GFC 07/08). In Part II, we will see why this is not as big of a concern for me as it normally would be (Hint: It is why the years 2001, 2002 and 2008 are italicized and underlined in the above table), but it is still important to remember that every strategy has its downsides.
In the next post we will go over my second rule for asset allocation decisions.
Here are the other two relative return charts that compare U.S. to EM and Foreign Developed to EM: