So here are three alternatives that lower the risk of taking the plunge into overvalued assets.
- Chose a rebalancing rule that lessens the impact of over- or under-valuation in your initial portfolio. The “overshoot” rebalancing rule outlined in the discussion of rebalancing would work well: you only rebalance when a particular asset deviates significantly from your target allocation. That would lower the damage from rebalancing to an asset class that continues to fall, but it won’t save you from losing money on your original allocation.
- Implement your initial asset allocation gradually. You could build your portfolio gradually over a year, or two years, or five years. Advantage: you’ll buy the assets at an average cost of their prices over that period. Disadvantages:
- The potential opportunity cost of leaving your savings in cash rather than stocks, bonds and real estate;
- Delaying the benefits of frequent rebalancing once you’re up and running (buy low, sell high); and
- Higher trading costs as you purchase your ETFs (and closed-end funds) in multiple small blocks rather than a few large blocks.
- Find some way to determine whether stocks, bonds and real estate are fairly valued, and only buy them when they are. The challenge, however, is arriving at an estimate of fair value for the various asset classes that you trust. Even professionals disagree profoundly about this issue. Wall Street firms, for example, employ “strategists” who focus on exactly the question of how exposed to equities portfolios should be, given current valuation levels. But they frequently disagree with each other (see table below), and in aggregate there seems to be little correlation between their intelligence and their track record.
In sum, none of the three solutions to the problem of when to implement your long-term asset allocation goals is entirely satisfactory. Your decision of when to buy stock, bond and REIT ETFs will inevitably involve subjective judgment, and the chances you will buy at the best possible level are minimal.
However, it’s important to keep two things in mind. First, over long periods of time, portfolio rebalancing will ensure that your portfolio reaches your target allocation, and then benefits from over and under-valuation of asset classes. And second, whichever approach to investing you adopt you’ll choose an initial asset allocation, whether you do it consciously or not. (Go figure what your current asset allocation is; it may shock you.) But with the approach I’ve described, you think clearly about your desired asset allocation, and understand the risks of buying asset classes during periods of overvaluation.