Reduce Drawdown By Allocation Switch - A Portfolio Review Tool

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Includes: IUSA, IVV, SPDN, SPXL, SPY, ULPIX, VOO
by: George Bijak

Summary

Static Strategic Asset Allocation offers insufficient downside protection during stock market crashes.

Advisors now have an additional portfolio review tool – Allocation Switch – for making rational decisions on when to switch clients’ asset allocation resulting in lower drawdown.

The tool applies the principle: ‘profits drive stocks; asset allocation drives risk and return.’.

Investors will appreciate the proactive cautiousness at the inevitable next stock market crash.

Investment Advisors Have a Problem

Strategic Asset Allocation (SAA) does not sufficiently protect investors on the downside during stock market crashes, when protection is most needed. Unfortunately, most stocks crash together, regardless of their quality, sector or region, and 'spreading the eggs among many baskets' amounts to little more than having car insurance cover that does not apply when an accident happens. The wave of litigation following the Global Financial Crisis (GFC) is a case in point.

Investors tend to make the situation worse by 'following the market' with their equities asset allocation, i.e. switching the allocation in line with the market trend: They buy more shares at the top of the market just before it crashes and sell at the bottom when the market is about to recover.

There is a Solution: Allocation Switch - A Powerful Risk Mitigation Tool

Advisors should be switching their clients' SAA in line with Corporate Profits growth trends. The allocation should be switched to a more defensive SAA option when profits growth is weak and to a growth option when profits are clearly rising.

The Allocation Switch methodology requires switching the SAA option every one to five years.

The long periods between SAA switches make the strategy a powerful risk mitigation tool that Investment Advisors can use at their annual client reviews to enhance their effectiveness.

Allocation Switch Follows the Profits

Advisors should recommend to investors, who generally 'follow the market' with their asset allocation, to 'FOLLOW THE PROFITS' instead, as summarized in the below figure:

allocation switch table

The Allocation Switch is particularly applicable to risk tolerant investors, who choose as default a High Growth SAA with maximum exposure to equities. Any switch recommendation by the advisor for high growth clients can only reduce allocation to risky equities and, hence, reduce portfolio drawdown. Reduction in shares allocation can also result in lower returns, but investors value downside protection more.

Historically, almost half of the 'weak' profits growth experienced a stock market crash with falls exceeding 20%. Chasing the last profits in a cycle with exposure to such large drawdown is not worth it. History provides the evidence - the drawdown deepened when profits growth was weaker:

drawdown follows weak profits

No Need to Forecast

There are models that attempt to forecast profits growth. However, to implement the allocation switch in its basic form, advisors can just watch the actual quarterly profits published by the US Government and switch the allocation in line with the main clearly emerging profit trends.

Market Follows Profits

Over the past 70 years, the Corporate Profits for the whole USA economy were over 90% correlated with the S&P 500 index (NYSEARCA:SPY), (NYSEARCA:IVV), (NYSEARCA:VOO), (IUSA), (NYSEARCA:SPDN), (MUTF:ULPIX), (NYSEARCA:SPXL) - a representative of the broad USA equities exposure. Two lines trending together on the CPGLI chart below depict the fundamental relationship during and post GFC.

usa stock market follows profits

The profits indicated on the chart are the seasonally adjusted National Income and Product Accounts (NIPA) Corporate Profits. They are calculated quarterly by the USA Government Bureau of Economic Analysis www.bea.gov.

Allocation Switch is Applied to Base SAA

An SAA that is matched initially to the client's risk profile (we call it a 'Base' SAA) requires committing to the static asset allocation for the long term - typically 10 years. This commitment is in the hope that all asset classes should return their historical averages over time. In reality, the static SAA mantra of 'staying put' is not practiced by individual or professional investors, who quite often switch their asset allocation at a wrong time.

The Allocation Switch, based on Corporate Profits, calls for moving up or down (i.e. more or less exposure to equities) from the Base SAA option in response to changing market risk. It provides investors and their advisors with a rational tool to stop them making the wrong emotional re-allocation choices. In the process, application of the Allocation Switch to the initial Base SAA should reduce portfolio drawdown.

The Real Issue

Allocation adjustments are made irrationally at the wrong time by investors responding emotionally to extreme stock market swings, resulting in painful losses. Investment Advisors are usually not involved in making of the re-allocation decisions but rather are blamed by investors for not trying earlier to protect them on the downside.

Investors tend to panic when the stock market crashes 20% to 50% and many sell at the worst time - generally around the bottom of the market just before recovery.

Here is the evidence: the below AAII chart shows the prevailing conservative and wrong 'follow the market' investment approach by individual investors.

individual investors allocation to equities

The actual allocation to equities is not static - it fluctuates between 40% to almost 80% in line with the stock market trend. A falling market triggers reduction in the allocation and a rising market is followed by gradual increase in the allocation to shares.

Highly skilled professional investment strategists who advise large fund managers are on average no different to individual investors in that regard. Perhaps they are also reluctant to stand up against the prevailing mood of the market, influenced by their conservative fiduciary duties.

Consensus allocation to stocks on the chart below was reduced in line with the falling stock market through to early 2009 and then only gradually increased with the rising market.

strategist allocation to equities Source: Bespoke Investment Group, Bloomberg Survey of Wall Street Strategists, Jan 2010. Reproduced with permission.

The point of lowest allocation to equities coincided with the March 2009 market bottom. Looking back, it was the best time to switch to a High Growth SAA option at the beginning of the multi-year V-shape rally.

Perception of Risk Depends on the State of the Market

The SAA methodology measures risk in terms of a long term historical average volatility without referring to current valuations. It implies that the market can move in either direction by the same magnitude from any entry price point.

But surely, the entry price does matter. And one does not need to forecast the market to know that the risk of a fall is bigger at very high valuations because history shows that markets are cyclical. Yet, static SAA expects the same allocation to equities at both low and high valuation entry points. Clearly, there is a need for rational asset re-allocation tools.

Investors look at the drawdown of their portfolios on a given day when they think about their downside risk. Investors' perception of risk changes with market performance. When the market is booming, investors are prepared to have a bigger exposure to shares; when the market is crashing, they dump their stocks and do not want to come back until they recover. I think Warren Buffett, among others, illustrated how irrational such behavior is: When we see a 'sale' sign in a shop, we rush to buy more of the goods at discounted prices and when prices rise we buy less. However, when it comes to the stock market we do the reverse: We buy less when shares are very cheap after a crash and buy more when shares are very expensive and likely to fall. That is how humans react to painful loss thus there is a clear need for rational tools to counter such irrational and costly behavior.

Investment Advisors have an educational role to play here: They should explain to their clients that when markets are booming while the profits growth trend is fundamentally beginning to weaken they should be gradually pro-actively reducing exposure to equities because of the greater probability of a fall.

Conclusion

Static Strategic Asset Allocation on its own does not provide sufficient downside protection during stock market crashes. In response, Investment Advisors should apply supplementary rational tools for portfolio reviews - such as the Allocation Switch based on Corporate Profits growth trends - that attempt to pro-actively deal with the extremely volatile nature of the stock markets and with irrational investor behavior.

More conservative advisors may choose to only apply the asset re-allocation tool to reduce their clients' exposure to equities in times of weak profits growth. This move should reduce portfolio drawdown and is worth the effort even at the cost of occasionally lower returns.

Investors will appreciate the proactive cautiousness at the inevitable next stock market crash.

Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.