Dynamic Risk Tolerance and Stock/Bond Mix
 11-22-2013, 09:52 PM #1 Recycles dryer sheets   Join Date: Aug 2013 Posts: 349 Dynamic Risk Tolerance and Stock/Bond Mix I’ve been thinking of my asset allocation and stocks, bonds, cash ratio. Some people set stocks to bonds based on using their age in bonds, or a risk tolerance questionnaire. For me it seems that my risk tolerance varies based on market conditions and the size of my portfolio so I’m trying to develop a dynamic asset allocation model that would accommodate that. Here is how I think about my risk. 1. When I’ve “won the game” exactly, I’m not very interested in risk. When I am not winning the game I am more interested in risk because I want a greater return. When I’ve won the game by a good margin, I’m more interested in risk so I can maximize my return. 2. When the market seems overvalued based on certain measures like the PE 10 Ratio or some other means, my appetite for risk is lower. When the market is undervalued based on those measures, my appetite for risk is greater. Taking both those into account, when my appetite for risk is the strongest in #1 and #2, I want to be all in; for me all in is an 80/20 portfolio. When my appetite for risk is the lowest, I want to be all out; for me that is a 20/80 portfolio. Here is what I’ve come up with for a mechanism to determine where on the 20/80 to 80/20 range I’m going to calculate a number from 1-10 for each of the above ways of thinking about risk. 1 = minimum risk, 10 = maximum risk. I will multiply those numbers together. That will return a value from 1 to 100 that will serve as the percentage of risk to take within the range. So if the risk for #1 is 5 and risk for #2 is 7 then 5 * 7 = 35%. That means I’ll take 35% of the risk over a non-risky 20/80 mix, in other words 20% + ((80-20) * 35%) gives me 20% + 21% for a stock / bond mix of 41 / 59. Now to come up with a formula for calculating the 1 to 10 numbers for #1 and #2 above. #1 came to me pretty quickly. Here are my definitions. X = (Networth - Equity in Primary Residence + Lump Sum Value of Pensions, SS, Annuties) / Annual Expenses Winning X = The point at which you've "won" the game with no need for extra risk. = (100 - Age)/2 + 10 My formula then for calculating the first number is as follows. ABS (X – Winning X) with a ceiling of 10 and a floor of 1. So if my current portfolio is 40x my expenses and my Age is 47 then the number is ABS(40 - 36.5) = 3.5 I am still thinking about creating a multiple for #2 on based on how fairly some of the various market valuation methods. One way I thought of was to take 5 – (PE10 – 16.5) and again use a floor of 1 and ceiling of 10. This way if the PE10 were 5 points over the historic average my risk appetite for measure #2 would be 1. And if it were 5 points under the historic average my risk appetite would be 10. Any ideas for figuring out a calculation for #2? Does anyone have any thoughts on taking this type of approach for determining a stock / bond ratio? I could recalculate the ratio quarterly, semi-annually, and adjust my allocation when I rebalance. I don’t really consider it a market timing approach as it is adjusting my holding based on my risk tolerance, which is dynamic based on those two factors. On the surface it looks like I’d be increasing stock allocation when stock prices are lowest and my portfolio is below or beneath my winning X. And I’d be having my lowest stock allocation when I’m right at my number and the market is overvalued. I welcome some input. __________________ __________________
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11-23-2013, 09:16 AM   #2
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Quote:
 Originally Posted by aim-high I welcome some input.
Okay.
Too complicated and arbitrary. To know if this is any better than setting an allocation somewhere in the mid-range and just rebalancing to that, you'd have to look at how your system would have done historically.
Also: about the "reduce stocks when I've won" parameter: Because stock prices are volatile, you'd need a smoothing function to avoid frequent selling and buying.
If having this formula-based approach helps prevent you from reacting to emotions when you have a hunch that stocks are overvalued (by PE10) or that you are holding more than you need because you've "won", then it might have value for you. I think most people will be better off with a fixed allocation and mechanical rebalancing.
Other inputs:
-- Take time to read the recent articles and studies that argue for higher (not lower) stock allocations in the later years of retirement ("sell off the bonds first"). It's worth thinking about.
-- If you set up this system in order to prevent arbitrary emotional selling\buying, won't you likely question its historic underpinnings and true merit when emotions run high? It's nice to be using a system/method that is simple and which has been looked at by others and found to work.
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11-23-2013, 09:48 AM   #3
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Quote:
 Originally Posted by samclem Okay. Too complicated and arbitrary. To know if this is any better than setting an allocation somewhere in the mid-range and just rebalancing to that, ....
Or even NOT re-balancing, which doesn't seem to have any clear advantage for returns. Though, like the rest of your post, it might provide some mental comfort that one is maintaining a certain pre-determined risk level.

-ERD50
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 11-23-2013, 11:03 AM #4 Give me a museum and I'll fill it. (Picasso)Give me a forum ...   Join Date: Nov 2010 Location: Vermont & Sarasota, FL Posts: 16,424 I think you need a hobby. Seriously, all you are doing is trying to devise a logical scheme to time the market. If you want to market time then go ahead and do so. If you want to invest, then pick an AA you are comfortable with given your age and risk appetite and stick with it. You can always rebalance "opportunistically" as a way to satisfy your need/interest in market timing. __________________ If something cannot endure laughter.... it cannot endure. Patience is the art of concealing your impatience. Slow and steady wins the race.
 11-23-2013, 11:22 AM #5 Recycles dryer sheets   Join Date: Aug 2013 Posts: 349 I appreciate the input from all. Thanks. __________________
11-23-2013, 11:31 AM   #6
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Quote:
 Originally Posted by aim-high For me it seems that my risk tolerance varies based on market conditions and the size of my portfolio so I’m trying to develop a dynamic asset allocation model that would accommodate that. Here is how I think about my risk. 1. When I’ve “won the game” exactly, I’m not very interested in risk. When I am not winning the game I am more interested in risk because I want a greater return. When I’ve won the game by a good margin, I’m more interested in risk so I can maximize my return. 2. When the market seems overvalued based on certain measures like the PE 10 Ratio or some other means, my appetite for risk is lower. When the market is undervalued based on those measures, my appetite for risk is greater.
Regarding item 2 above, it is logically and mathematically sound. If one is willing to hold 50% stock at a high stock price (based on PE10 or something similar), he should be willing to hold a higher stock AA when the market crashes. The reason for this is that both the potential reward and the probability of a higher market price are higher after a market crash, hence equity AA deserves a higher bet.

For a mathematical proof, search for "Kelly Criterion", which tells you how much one should bet if the odd of winning and the pay-off are known. In the stock market, neither can be determined that well to apply the math formula. But one can still think of this in a more qualitative sense.

However, in real life we all know one should load up on stocks after a market crash, and we also know how hard it is to resist the flight impulse. It is tough enough to maintain constant AA at market bottoms.
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 11-23-2013, 02:25 PM #7 Thinks s/he gets paid by the post   Join Date: Jul 2005 Posts: 3,862 An interesting idea, I would consider something like it if I wanted to time without feeling bad about it. 1) Multiplying the two numbers is going to pretty consistently tilt towards the low risk end. I would think a 5 for each number would be sort of middle of the road, but it gets you only 25% of your available risk portfolio. You're kind of letting either number scare you out of equities, while both of them have to be good before you get lots of equities. That might be what you want, but it will result in a fairly conservative portfolio (less than 50% stocks) under fairly normal conditions. 2) If the metrics move quickly, you formula will be demanding that you buy and sell with potentially lots of turnover. Both costs and taxes associated with that that could drag your performance down. __________________
11-23-2013, 02:53 PM   #8
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Quote:
 Originally Posted by Animorph An interesting idea, I would consider something like it if I wanted to time without feeling bad about it. 1) Multiplying the two numbers is going to pretty consistently tilt towards the low risk end. I would think a 5 for each number would be sort of middle of the road, but it gets you only 25% of your available risk portfolio. You're kind of letting either number scare you out of equities, while both of them have to be good before you get lots of equities. That might be what you want, but it will result in a fairly conservative portfolio (less than 50% stocks) under fairly normal conditions. 2) If the metrics move quickly, you formula will be demanding that you buy and sell with potentially lots of turnover. Both costs and taxes associated with that that could drag your performance down.
Agreed. I am going to play around with the numbers some more. I think you're right about two 5's wanting me to be 50/50. Maybe instead of multiplying them, average them.

For me, it's really not about trying to time the market as it is about managing my risk tolerance and maximizing my profits.
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11-23-2013, 04:21 PM   #9
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Quote:
 Originally Posted by aim-high Agreed. I am going to play around with the numbers some more. I think you're right about two 5's wanting me to be 50/50. Maybe instead of multiplying them, average them. For me, it's really not about trying to time the market as it is about managing my risk tolerance and maximizing my profits.
Average them and you essentially have each one controlling half of your risk portfolio independently. Not sure that's really what I'd want either, but it might be less biased.
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 11-23-2013, 05:53 PM #10 Recycles dryer sheets   Join Date: Nov 2013 Posts: 178 What caught my attention is "won the game". I'm new here... I was browsing various topics yesterday and found a link to this article: The worst retirement investing mistake - Sep. 4, 2012 "When you've won the game, why keep playing it?" We have won the game... now I find myself becoming much more risk averse. It's more difficult to find an AA I'm comfortable implementing. aim-high, I like your idea... it might be worthwhile to create Excel spreadsheet to help visualize different scenarios. __________________
11-23-2013, 06:29 PM   #11
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Quote:
 Originally Posted by aim-high For me, it's really not about trying to time the market as it is about managing my risk tolerance and maximizing my profits.
If you're moving in and out of the market on the basis of PE10 or other valuation measures, you are market timing. I would simply accept that I am a market timer and read *all* the papers I could find on this. Calling it dynamic risk tolerance doesn't change what you are doing.
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11-23-2013, 08:10 PM   #12
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Quote:
 Originally Posted by 34rlsa What caught my attention is "won the game". I'm new here... I was browsing various topics yesterday and found a link to this article: The worst retirement investing mistake - Sep. 4, 2012 "When you've won the game, why keep playing it?" We have won the game... now I find myself becoming much more risk averse. It's more difficult to find an AA I'm comfortable implementing. aim-high, I like your idea... it might be worthwhile to create Excel spreadsheet to help visualize different scenarios.

For myself, I feel like I've also "won". I probably should be cutting back on equities now that I've retired and only have three more years "income" from a buyout of my practice, but am loath to sell stocks I've owned for a long time and pay taxes, and find it hard to break a lifetime of investing in equities habit.

I do however have about five years expenses in cash, which I won't need to start drawing upon until three more years. But I just can't make myself move into bond investments in a taxable account at today's interest rates. I figure I'm giving up 1% or so on that cash vs what I'd earn in safe, short term bonds, and I'm willing to do that rather than risk any nominal loss on that money.

I've considered making some planned gifts, getting tax deduction now, and set up some guaranteed income at a later date. But my relatively low understanding of the gift annuities leads me to believe that the income they compute is also based on current low rates. Anyone have any experience with charitable annuities?
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 11-23-2013, 08:51 PM #13 Recycles dryer sheets   Join Date: May 2013 Posts: 213 I actually like this concept. I skipped over your formula but I did read your justification and It makes sense to me. You may not maximize returns, but you'll likely maximize nights of sleeping well which is vastly more important once you've won the game. __________________
 11-23-2013, 09:38 PM #14 Full time employment: Posting here.   Join Date: Nov 2008 Location: Harrogate, UK Posts: 864 I've never really understood the negative attitude towards market timing. Yes....I understand that jumping in and out of the market hoping/planning for a turn one way or another is risky "at the best". But....if the S+P went up 100 points this Monday and I said to myself "Good enough....I'll take it and get out". Is that sooooo bad? Would you do something else? When the market goes WAY down....people buy in. Is that wrong? It's timing.... __________________
11-23-2013, 11:15 PM   #15
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 Originally Posted by F4mandolin I've never really understood the negative attitude towards market timing. Yes....I understand that jumping in and out of the market hoping/planning for a turn one way or another is risky "at the best". But....if the S+P went up 100 points this Monday and I said to myself "Good enough....I'll take it and get out". Is that sooooo bad? ...
When do you get back in?

-ERD50
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 11-23-2013, 11:36 PM #16 Recycles dryer sheets   Join Date: Nov 2002 Location: Alajuela, Costa Rica Posts: 220 OP is another idea about market timing i.e. gambling. Not for this investing veteran of 30 years. __________________
11-24-2013, 09:03 AM   #17
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Quote:
 Originally Posted by F4mandolin I've never really understood the negative attitude towards market timing. Yes....I understand that jumping in and out of the market hoping/planning for a turn one way or another is risky "at the best". But....if the S+P went up 100 points this Monday and I said to myself "Good enough....I'll take it and get out". Is that sooooo bad? Would you do something else? When the market goes WAY down....people buy in. Is that wrong? It's timing....
This is the kind of thinking having 58 beers leads to...
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11-24-2013, 11:04 AM   #18
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Quote:
 Originally Posted by aim-high ...(snip)... Here is how I think about my risk. 1. When I’ve “won the game” exactly, I’m not very interested in risk. When I am not winning the game I am more interested in risk because I want a greater return. When I’ve won the game by a good margin, I’m more interested in risk so I can maximize my return. 2. When the market seems overvalued based on certain measures like the PE 10 Ratio or some other means, my appetite for risk is lower. When the market is undervalued based on those measures, my appetite for risk is greater. ...
This looks pretty reasonable for a start. For me #1 is much more important then #2. For #1 I can do historical analysis, but for #2 it is not so easy a call (as PE10 can show over valuation for some years before maybe something bad happens).

To check out #1 I've recently done some fairly elaborate massaging of FIRECalc spreadsheet output. But for a quick check I've just run FIRECalc with two separate AA's (maybe 50/50 and 65/35 which is the current AA for us). The main settings in FIRECalc are:
1) Set initial spending level to maybe 4% of current portfolio
2) Spending Models tab - select percentage of remaining portfolio, 95 in box
3) Investigate tab - set leave some money in estate to maybe 50% of current portfolio and also "Given success rate, determine spending level ..."

I chose to have an estate (in 3) because who wants to go near zero? That is unrealistic and scary too.

Anyway, if the spending is very good then I've probably won the game. Especially when we've gone several years into a recovery, then it is reasonable to dial back the risk.

So that's what I'm planning on doing, reducing equities. For me it is hard to reduce equities because it's a battle between greed and fear and I'm a bit of a gambler.
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11-24-2013, 12:56 PM   #19
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Quote:
 Originally Posted by F4mandolin I've never really understood the negative attitude towards market timing. Yes....I understand that jumping in and out of the market hoping/planning for a turn one way or another is risky "at the best". But....if the S+P went up 100 points this Monday and I said to myself "Good enough....I'll take it and get out". Is that sooooo bad? Would you do something else? When the market goes WAY down....people buy in. Is that wrong? It's timing....
Considering our expertise (hopefully successful or soon to be ER's) and the likely investing competence of those we try to advise (pretty much completely unknown, but often investing beginners), we'd be pretty reckless to advise any sort of market timing. Particularly without a specific plan (not gut feel), and without a robust and public track record. I have been reasonably happy with my timing attempts, but I do not think I could easily impart a good strategy to someone else beyond what I have described here previously. And we have all heard plenty of stories (some of them here) of timing gone wrong. We simply do not have a vetted plan for market timing for beginners (excepting perhaps LOL!?).

I haven't seen any replies to the OP that have suggested some old reliable market timing formula similar to what the OP proposes that provides investment returns similar to buy and hold. When we have something like that, with some academic research support and reasonable expectations for the future, maybe we, as a group, could start to recommend something like that to new posters here with unknown investment experience. Until then, we feel comfortable with what we are recommending, and those who feel comfortable doing something more adventuresome (or less) can diverge from those recommendations at their own risk.

One of my experiences: I went to about 30% cash in early 2007, before I retired in late 2007. That was a few years of expenses, (with college and no SS yet) and I did expect at least a bear market soon. The market went up about 10% after I took the cash out. Oops. Finally, the market went down 20%, a bear market. Of course it was only 10% down from when I took out the cash. I got rid of some of my other hedges, but left the cash. The market then went up 5%-10% (IIRC). Time to get back in or not? Is it a recovery or just a glitch? I hang on with my cash. Then things start going seriously down. When do I buy in? I guessed at a -40% bottom (I ended up right at -50% with my particular mix) and bought back into the market at 5%-10% steps on the way down to -40%. An extra 10% down to -50% and I put HELOC loan money into the market and was ready to start shifting my AA away from conservative investments and more towards aggressive small-cap stuff. At the market bottom of course there were plenty of gurus saying the market was going to go down to some really frightening level, and I had a few (like 3) months of expenses in cash now.

Then things went up, fairly quickly to start. I was able to sell stocks as needed, at a profit, as I needed cash for expenses on a monthly basis.

I'm fine, for myself, trying to time a really bad market. But really, from a pure investment standpoint, how closely can you predict a market peak? I hit it within 10% in 2007 and I was really happy with that. How closely can you predict the market bottom? I wasn't too close, I invested all the way down. But again, I basically got within 10% (of the original peak) with my =405 guess. Again, I think that's really good. So with a conventional -20% bear market I might break even with my timing. Not even worth trying.

I take cash out now because I'm going to use it for future near-term expenses and my portfolio has hit target balances. Hopefully that raises some cash when things are going too well and I'll have some cash when things go bad, without having a cash buffer sitting around dragging down my portfolio performance. I'll let you know how that works out in a few decades.
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 11-24-2013, 01:18 PM #20 Give me a museum and I'll fill it. (Picasso)Give me a forum ...   Join Date: Jul 2008 Posts: 19,403 Some people think of a market timer as someone who jumps all in or all out of equities. It does not have to be that way. Adjusting one's AA by 10 to 20% based on extreme market conditions is a prudent thing to do in my view, and not at all reckless like many people make it out to be. And speaking of one's performance during the 2008-2009 Great Recession, I just looked back at my record, just to refresh my memory of how I reacted, and to observe my past actions in a more objective manner. As I made a graph, and as a picture is worth a thousand words, I am thinking of sharing it in a new thread to be started soon. __________________ __________________ "Old age is the most unexpected of all things that can happen to a man" -- Leon Trotsky

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