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.
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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