In the post, “Probable Maximum Investment Loss – How to Control Your Investment Losses”, we learned how to tailor our asset allocation to our assumed probable maximum investment loss. Now we can further explore the asset allocation strategy that can successfully maneuver through the volatile times we currently live in.
Investment Loss and Asset Allocation
Asset allocation is what will determine over 90% of your returns. It is the most important decision you can make in investing. The stock market has earned an average of a little less than 10% per year over a long period of time. But the average investor’s actual returns are much lower because people tend to buy when prices are high and tend to sell when prices are low. Because people allow their emotions to control their investment decisions, their form of “timing the market” has proven to be detrimental to investment returns.
Tactical Asset Allocation Strategy
An active or tactical asset allocation is a dynamic investment strategy in which investors change their asset allocation based on current circumstances. Historical analysis has proven the valuation of investment assets when purchased will determine long term returns (time periods of 10 years or more). Buying at high valuations produces low returns. Buying at low market valuations produces better than average returns. Doesn’t it make sense when you invest to make sure the odds are in your favor?
When you buy is something you can control. You can’t control what happens after you buy. The odds are, if you buy stocks when valuations are high, your returns will be much lower than when you buy stocks when valuations are low. Virtually every stock market crash has begun from abnormally high valuations. On the other hand, investors who buy stocks when valuations are well below average have always done well over long periods of time.
Be conservative when valuations are high. Hold cash and be mentally prepared to buy more stocks when prices are bargains. Take some profits and raise cash after the stock market rises because it makes sense to not be greedy. Yes, you will underperform the market when it goes up, but so what! Who says you have to match the market when it’s going up? The point is: The breakeven loss analysis chart demonstrates how long term returns are affected more by preserving capital when the market falls than making money when it rises.
It is the long term that matters. Most investors are too short sighted and impatient; wanting instant results. Are you a gambler or an investor? If you buy over valued stocks you are gambling that someone will pay more than its intrinsic value at a later date. You might gamble and win for a time; but that is not investing and the odds eventually catch up with you.
You have been warned that the odds are against you if you buy when valuations are high. Eventually buy and hold investors get burned and suffer severe damage to their portfolio. Instead of listening to the financial industries buy and hold mantra; use a valuation based tactical asset allocation to minimize investment loss and greatly increase your odds of high investment returns.