Embrace the Bear Market with Overbalancing

After two false starts in January and March 2008, the stock market finally crossed over into bear market. The bear market is great because everything is cheaper. I quoted Warren Buffet in How Low Can It Go? Part 2 in January. It’s worth repeating:

"If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices." — Warren Buffett, Berkshire Hathaway Inc., 1997 Chairman’s Letter

I welcome the bear market with a 5% increase to the allocation to stocks in my portfolio. As mentioned in Cascading Asset Allocation Method, my regular allocation is 60% stocks, 40% bonds. That allocation fits the rule of thumb that stocks allocation should be (100 – age)%. Because stocks are cheaper now than what they were a year ago, I’m increasing my stocks allocation from 60% to 65%. From here on, I’m planning to increase it by 5% for every additional 10% decline until the stock market goes to 40% off its high, then I will accelerate to 5% more for every additional 5% decline. By this plan I will be 85% stocks, 15% bonds when the market goes to 50% off. Will it ever get there? I don’t know. If it does, my allocation will be more aggressive than my regular 60/40 allocation but it’s still not as aggressive as some of the target retirement funds for my age. For example Vanguard Target Retirement 2030 Fund has more than 85% in stocks now. Here’s how my plan looks like:


Stock Market Allocation to Stocks
-5% 60%
-10% 60%
-15% 60%
-20% 65%
-25% 65%
-30% 70%
-35% 70%
-40% 75%
-45% 80%
-50% or more 85%


Is this market timing? Yes and no. Yes I’m changing my allocation to stocks when stocks become cheaper. No I’m not predicting whether the market will go up or down or where the top or bottom will be. Nor am I getting in and out of the market. I’m just reacting in the same way when hamburgers are on sale. It’s called overbalancing in an article by William Bernstein, the author of great books The Four Pillars of Investing and The Intelligent Asset Allocator.

"Think of it this way: even the most devout efficient marketeers rebalance; trimming a portfolio back to policy is nothing more, and nothing less, than a bet on mean reversion. Taking the process one step further and adjusting the policy allocation itself opposite valuation changes is merely a way of amplifying a rebalancing move — "overbalancing," if you will." — William Bernstein, Mamas, Don’t Let Your Babies Grow Up To Be Timers

Why am I not 85% stocks now? Because I’m not willing to take that level of risk. But I will be when stocks go 50% off. Is overbalancing for everyone? Probably not. If you started with a high allocation to stocks, there’s not much room to add on the way down. Keeping the allocation is already painful enough.

Dear Bear Market, please stay with us for as long as you can. I will feed you honey.

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Comments

  1. G says

    Great post. Even though I know in my head that bear markets are good for net savers like me, it still hurts to watch the value of my portfolio fall – perhaps I should stop looking at it!

  2. Ted says

    The thing I don’t understand is when do you go back to 60/40? When the S&P gets back above the “bear” level? When it gets back to the “peak” level?

    Do you have a time limit for your overbalancing dispensation? What if the bear market takes 5 years going up and down to eventually wind down to -60% from the peak before it starts to go back up and then takes another 5 years to get back above water? Do you really want to “overbalance” for 10 years?

    Given the possibility of a protracted down turn, doesn’t overbalancing defeat the purpose of implementing an asset allocation plan in the first place?

    Have there been any studies to show this is potentially better than just sticking with your 60/40?

    I can’t help but think of the growth fund I owned in 2000 that still has never recovered. Perish the though of ever overbalancing that nightmare. Good money after bad money down the drain for 8 years!

  3. Eiji says

    Great post.

    I am reminded again of the mantra, “Buy low, sell high.”

    Most people seem to “Sell low, buy high,” based on emotional reaction to market price swings.

    Prices are low now so I’m buying. Bear market == Buying Opportunity.

    The only caveat is that if I’m already in retirement and have no choice but to withdraw from my retirement fund, then a market downturn is not pleasant. I can vary the amount I withdraw or vary which asset classes I withdraw from, but I probably still have to to withdraw some amount after a sustained bear market, unless I decide to go back into the workforce to get additional income. That would suck.

  4. TFB says

    Ted – The exit strategy — yes, never go into something without an exit strategy. My current plan is to unwind the overbalancing on the way up similar to how I increase the allocation to stocks on the way down, but with a delay, say 10%. For example I went to 65/35 at 20% off peak but I’m not going to feverishly add and remove 5% to stocks when the market bounces above and below the 20% off line. I would only go back to 60/40 when the market goes up to 10% off. This way I leave myself some cushion for buy-low-sell-high.

    I’ve been thinking about this for a while and I come to the conclusion that I picked 60/40 quite arbitrarily. Should it be 65/35? 70/30? I think I can comfortably live with any of those. 85/15? Not now, but if stocks go 50%+ off peak, I’ll be OK with that too. At no time do I have more in stocks than what Vanguard recommends for my age. So I think a variation from an arbitrarily picked number will be OK especially I’m buying more when the market is down.

    This is going to be done on a globally diversified portfolio. So I don’t think it will be like your growth fund in 2000.

  5. Rod says

    Hi TFB,

    While I understand the reasoning for this sort of thing, and it resonates to some degree, it seems to beg at least two question: (1) how to decrease stocks, and (2) down relative to what?

    You addressed question 1, but the answer seems to indicate a less than completely thought out process to get back in. Perhaps that is simply due to the limitations of a short post.

    As to question two: Could be down relative to the recent peak, although false rallies and such make that problematic; true peaks are only known in hindsight (same of course on the other side for bottoms). Super peaks also pose a challenge. Given a huge bubble like the late great tech induced bubble in the US markets, 10% down from the peak, or even 20% down from the peak does not necessarily denote a good buying opportunity.

    Seems to me down relative to the expected long term mean return would be better, if only there really were a long term expected (in a probabilistic sense) mean, and only if we knew what that value was.

    Another related approach would be to do something similar based on valuations; hold more when P/E was low and less when P/E is high. Similar caveats would of course apply as I mentioned above.

    Unfortunately for all of this, if it were really this easy, wouldn’t all the pros already be doing this and beating the pants off all the amateur buy and hold investors? Only they don’t.

    Rod

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