Match Your Asset Allocation To Your Outlook And Ability

Includes: DIA, IVV, SPY, VT, VTI
by: Martin Lowy

I have a new Seeking Alpha friend called "casca123". Casca and I don't agree on everything. In fact, we disagree about quite a lot. But casca is intelligent and does his research, as he demonstrated in comments to my article on Second Generation Immigrants.

Casca's comments, as well as a comment by SA reader "byloe n. selheigh" (great handle) to my article "A Portfolio for the Next Market Crash" got me thinking about asset allocation from a new perspective. I began to see that each investor probably should approach asset allocation from a personal point of view rather than only the point of view of what a robotic investment adviser would recommend for that person's age and financial circumstances. Perhaps we all should start from the robot's recommendation. But we should shape it based on two factors: our own view of the world and our own psychological ability to withstand market shocks.

Evaluate Your World View

My friend casca's view of the world at the moment appears to be more pessimistic than mine. He and I both see problems in American society, for example. But I think he is not optimistic that they are being dealt with. I see many of the same problems but believe that (1) they are not as urgent, and (2) that society is beginning to deal with them. I am optimistic about the future of the American economy and about corporations' ability to make profits. I guess that is because I am basically an optimist. Stuff happens, of course-always has and always will. But people in a democracy manage to muddle through. I suspect that these days casca has less faith in that.

I also see great long-term benefits to the economic rise of so many people in countries that have lower GDP per capita than America has. Their rise is, at this point in the global economic cycle, costing Americans jobs, and it is tending to drive down the earnings of many Americans. But longer term, adding hundreds of millions of people to the middle class will create markets for the products and services of well-run businesses and good jobs for clever people. Americans, as well as others, will, I believe, take advantage of those opportunities. We need to make our educational systems better and more efficient to help Americans to do that. But I see that happening already, everywhere from pre-school through college. We are only at the beginning of a great educational revolution, I believe, and that revolution will enable Americans and the United States to continue to flourish. Bipartisan support for these initiatives is gathering momentum, despite the deep divide that exists on most issues.

Based on my optimism, I am willing to continue a substantial allocation to equities (about 50% at the moment) even though I am at an age where the robot would reduce that allocation for me.

If, unlike me, you are pessimistic about the ability of Americans to solve our problems, whatever you think the most important ones are, then perhaps you should translate that pessimism into a portfolio allocation that suits your view. The portfolio should have less risk than mine, since if you are correct, then less risk will be right course.

I recognize that many professionals would disagree with me. Follow the robot, they would say, because you (meaning any of us) really do not know anything, and basing your portfolio decisions on emotional things like optimism or pessimism is a defective way to make investment decisions. I can see that professional point of view. But I truly believe that I am more likely to be right than wrong about the basic trend of the future. And many SA readers will feel the same way. They are informed people who want to remain informed. If you believe you are correct, then it seems to me to be appropriate to modify your risk level based on what you believe. You or I are just a likely as the robot is-or the robot's keepers are-to be right about the big picture version of the future.

When you make your personal assessment, however, please do so as dispassionately as you can. Ask yourself how certain you are. Ask yourself how you will feel if you are wrong. If you do not have confidence in your assessment, then by all means, go with the robot's recommendation. If the robot is wrong, at least you will have someone else to blame.

Measure Your Ability to Stay the Course

Our friend byloe n. selheigh may be even more optimistic than I am. He takes the view that if he has 37% in cash, "I figure this gives me enough reserve to ride out any foreseeable plunge, while still drawing a nice return." Byloe has a higher allocation to equities than I have, but he trusts in his ability to remain steadfast through bad markets. I like byloe's approach, even though it is not for everyone.

What did you do with your portfolio in response to the financial crisis? Probably it is painful for you to remember it in detail. It is for me. But your reaction in 2007-2009, taken together with what you think you learned from that experience, should help you to decide how much of your portfolio should be allocated to equities or other risk assets.

I learned that even though I made a good guess as to when the market was overpriced, I neither sold enough nor understood the depth of what was coming. And I do not think I will be much better at it the next time around. What I was good at was calling the bottom in early 2009. I did not know why it was a bottom, I just knew that going practically all in was the thing to do right then simply because markets overshoot, and I was confident that the overshoot had occurred. I hope I do not have to do that again. It made my stomach queasy. Basically, I was just following Buffett's advice to be greedy when others are fearful.

Those experiences have made me skittish of believing that I could protect myself very well in the moments before everything goes cablooey. And once cablooey begins, who has the courage to decide that it really is Armageddon and you have to sell at any cost? Or is it, perhaps, just a normal cyclical dip that calls for buying, as I erroneously thought early in 2008?

If you went through the 2007-2009 period, you know what you felt and what you did. I believe you should use that experience to shape your asset allocation decisions.

Today, the U.S. stock market is overpriced by many traditional measures. Doug Short and Cullen Roche wrote articles on that subject in recent days. On that basis, the warning lights are flashing right now. On the other hand, neither bonds nor cash look attractive. And in a low interest rate environment, there may well be room for the market to continue its upward trend. To my eye, the market seemed overpriced already in 2010, and I dialed back my risk level. What should we do now? I am on record as to my medium term views, though forecasting markets in the short term seems to me like a mug's game.

Regardless of whether an investor follows the robot's recommendations for portfolio allocations, I think every investor should have made a personal decision and should strive to understand the risks that really are embedded in the resulting portfolio. Safety often is an illusion.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.