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William Sharpe's paper: Adaptive Asset Allocation
Old 09-05-2010, 08:35 AM   #1
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William Sharpe's paper: Adaptive Asset Allocation

He suggests that conventional Asset Allocations (by rebalancing to the initial AA) be adjusted (adapt).


http://www.stanford.edu/~wfsharpe/retecon/wfsaaap.pdf
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Old 09-05-2010, 10:18 AM   #2
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His specific example of such a policy:

Quote:
“The fund’s Asset Allocation Policy is to have 80% invested in stocks and the remainder in bonds when the market value of stocks is 60% of the total value of stocks and bonds, with the proportions to be determined each period using the adaptive asset allocation formula.”
So, for example, if the total bond market value were to expand greatly over a period of time due to an explosion of debt and a drop in prevailing interest rates, while stock values dropped or stayed steady, then the market value of stocks might drop to 50% of the total value of stocks and bonds.

Figure 3 on page 25 shows the suggested adaptive allocation most clearly. At a 60% market valuation for stocks, the fund's stock allocation is 80%. When the market valuation of stocks drops to 50%, the fund's stock allocation would be around 73%. If the market valuation of stocks drops to below 45%, the fund's stock allocation would drop below 70%.

As it happens, this last set of numbers is pretty close to current conditions. The effect is that a fund's 80% stock / bond mix chosen for the "normal" 60/40 mix of stock and bond values in the total combined market might be adjusted to 70% today.

I get the math, for the most part. But I'm having some trouble with the premise that there is a "normal" mix of stock and bond total market values.

Seems to me that the total debt market value over time is highly susceptible to non-economic factors, like the government policy and regulation mix that determines how easy mortgage and consumer debt is to obtain. Or, in the other direction, a tax code change that encourages companies to go public and sell stock, leading to an increase in the total stock market value that is not market-based.
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Old 09-05-2010, 12:08 PM   #3
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I haven't read the article yet, but...it sounds like market timing to me--the belief that we can predict the future. Like Gummy, my crystal ball is out of batteries. Maybe he can do it. I never could.
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Old 09-05-2010, 01:43 PM   #4
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I enjoy reading Sharpe's well-written articles and his provocative thinking.

But I no longer trust his objectivity. He's already said that he's glad the Nobel committee can't repossess their awards, and his equity in FinancialEngines.com (now a publicly-traded stock) makes me suspect that he's moved from academic books to talking his book.

I think he should've rested on his laurels when they started naming ratios after him. It's all downhill after that...
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Old 09-06-2010, 12:47 AM   #5
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I think someone named a ratio after me. Ever hear of The Misery Index?
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Old 09-06-2010, 09:45 AM   #6
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Old 09-06-2010, 11:46 AM   #7
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I did the highest level scanning, but it appears he is talking about institutional investors, not individuals. Basically, if an institutional investor claims to be making AA decisions which are appropriate for the "average investor", it seems that the institution should at least consider the relative market values of the different asset classes. After all, isn't the market just the sum total of all investors?

I suppose that makes sense, I'm not sure if it is relevant for one of us selecting an AA. We might think that Buffet is right and it's better to be a little contrarian. I suppose it makes sense to be aware of the totals as one piece of information, it might tell us to what extent we are going against the average.
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Old 09-06-2010, 12:55 PM   #8
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I only skimmed also. The piles of equations put me off but I did get the impression that he feels there is currently insufficient data available on generic bond/equity market valuations. So his method doesn't have a means for the average Joe.
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