Dan Ariely recently went off on the standard practice of constructing an asset allocation based on the expressed risk tolerance of an investor:
We also asked people to tell us how much risk they were willing to take with their money, on a ten-point scale. For some people we gave a scale that ranges from 100% in cash on the low end of the risk scale and 85% in stocks and 15% in bonds on the high end of the risk scale. For other people we gave a scale that ranges from 100% in bonds on the low end of the risk scale and buying only derivatives on the high end of the risk scale. And what did we find? People basically looked at the scale and said to themselves “I am a slightly above the mean risk-taker, so let me mark the scale at 6 or 7.” Or they said to themselves “I am a slightly below the mean risk-taker, so let me mark the scale at 4 or 5.” In essence, people have no idea what their risk attitude is, and if they are given different types of scales they end up reporting their risk attitude to be very different. (my emphasis added)
Source: Stephen Cohen
Anyone involved in this business can attest to the fact that the expressed risk tolerance of the same individual can vary, even dramatically, over time.
Source: Peak Wealth
What can be done to minimize the problems associated with being too bullish at the top and too bearish at the lows? For starters, it makes zero sense to rely on an investor’s expressed risk tolerance when constructing an asset allocation–as pointed out above by Dan Ariely. Furthermore, reliance on an investor’s age also presents another set of problems (bonds can also have horrific drawdowns.) Also popular is the practice of reliance on long-term historical inputs, such as variance, expected return, and correlation, in order to construct the “optimal” portfolio. We’ve frequently dealt with the fallacies of modern portfolio theory.
What does that leave us with? Our preferred method of helping clients avoid the problems associated with emotional asset allocation is “the bucket approach” as we discuss in The Upside of Mental Accounting. Furthermore, I would submit that a core piece of that allocation should be invested in a global tactical asset allocation strategy, driven by relative strength. Unlike portfolio construction based on expressed risk tolerance, age, or historical modern portfolio theory inputs (all of which are based on things that the market doesn’t necessarily care one bit about), relative strength-driven asset allocation has the benefit of an increased likelihood of performing well in a variety of market environments. Importantly, relative strength-driven asset allocation will result in market leadership being represented in the portfolio. This means that the portfolio may have heavy exposure to currencies, precious metals, and fixed income at some parts of the market cycle and heavy exposure to domestic and international equities and real estate at another part of the market cycle (or many other portfolio combinations). The essential point is that allocation changes will be driven by relative strength, not some other factor.
Click here to view a 14-minute video on our approach to global tactical asset allocation.
To receive the brochure for our Global Macro strategy, click here. For information about the Arrow DWA Tactical Fund (DWTFX), click here.
Click here and here for disclosures. Past performance is no guarantee of future returns.
