The following is in response to Christopher Sidoni’s article, The Conflict between Tactical Asset Allocation and Behavioral Finance, which appeared on February 21:
Dear Editor,
In his recent article, Christopher Sidoni commented on our December 2011 Journal of Financial Planning article, Improving Risk Adjusted Returns Using Market-Valuation-Based Tactical Asset Allocation Strategies. Sidoni took issue with our proposed strategy of tactically changing portfolio asset allocation at valuation extremes using a simple rules-based valuation approach.
Sidoni suggested that clients will not allow advisors to take such a contrarian approach at extremes because market valuation is a poor tool for market timing. He argued that valuation-based asset allocation shifts can be “wrong” for long periods of time, leading to a risk that clients may abandon the strategy before they are rewarded. He also suggested that the strategy we proposed in our article does not yield high enough after-tax excess returns to offset the risk of a client revolt at market extremes for advisors who are “early” in making tactical shifts in their portfolio.
Hopefully Sidoni hasn’t missed the main points of our article. First, we did not, and do not, advocate that investors blindly use such a simple rules-based approach in managing portfolios if they are unwilling to stay the course. (Investors who are unwilling to stay the course, however, will not likely be happy with any equity-based investment strategy as the market goes through its volatile cycles!)
We set out to disprove the notion that market movements are random and that market valuation does not matter to future portfolio returns. Our research showed with a 99% level of statistical confidence that valuation, measured by using five-year normalized price-to-earnings ratios, does predict future stock market returns, as well as both stock- and bond-market standard deviations, over subsequent five-year periods. We then showed how implementing a simple rules-based strategy using market valuation as a method to change asset allocation could earn excess returns and significantly reduce portfolio volatility in down markets.
For many financial advisors who claim that tactical asset allocation, to the extent that it entails “market timing,” is purely a game of chance, we hoped the study would further their understanding of how market valuation-based tactical shifts can be more than just a guessing game. The evidence that higher returns can be had with less risk, we hoped, might encourage them to look further into the benefits of tactical asset allocation.
Sidoni was correct in his contention that market valuation can be “wrong” for long periods of time, and he correctly pointed out that clients may not be happy and may abandon the strategy of advisors who have made asset allocation shifts based solely on long-term market valuation. Clients may be equally upset, however, with advisors who persist in buying and holding asset classes when they are purchased at overvalued extremes and subsequently earn far less than expected historical average returns for the subsequent five- to 20-year period.
