Asset allocation: if you can’t be right, be consistent

It’s been a rocky last ten years in the financial markets. From 2002 to 2007, U.S. stocks doubled while international stocks tripled. Then came the plunge followed by a steady recovery. What was the right asset allocation during the past ten years? It turns out to not matter so much. The chart shows allocations from a conservative 30% stocks to an aggressive 90%. The stock portion in all portfolios was two-thirds U.S. and one-third international. All were calculated using Vanguard total stock index funds (2/3 US and 1/3 international) and the Vanguard total bond fund. All portfolios gained between 87% and 121%. The key to achieving these returns was consistency. All portfolios were rebalanced every six months, on June 30 and Dec. 31. In other words, the investor had to stick with their allocation no matter what. Being consistent in asset allocation is certainly simple but not very easy. We would have had to tell clients in 2007 that stocks will not go up forever and that’s why we are continuing to sell to rebalance back to their target allocation. Then in 2008, we would have had to convince the client that capitalism probably isn’t actually dead and we need to buy stocks during the half-off sale. Unfortunately, data demonstrates that few investors had the courage to be consistent, and research from Daniel Kahneman may reveal why. Kahneman won the Nobel Prize in economics for his behavioral economics work in developing his prospect theory. In simple terms, his work illustrates that investors get about twice as much pain from losing a dollar as they get pleasure from gaining a dollar. One can then infer that clients are twice as likely to panic and sell after plunges as they are to get greedy and buy after surges. Thus, especially now that markets are near an all-time high and investors feel like taking on more risk, picking a more conservative allocation may be in order. The next time markets tank, we can remind the client that we started more conservatively than they wanted and the rebalancing is now buying those equities at a lower price. Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct instructor at the University of Denver.