The importance of using value strategies in asset allocation decisions cannot be overstated. Your asset allocation will be the main determinant of your investment returns. Don’t be the kind of investor that puts the majority of your efforts into picking individual investments and then makes asset allocation mistakes that destroy your portfolio value.
The average investor makes decisions that cause them to underperform average investment returns. The difference between average investment returns and average investor returns is often called the behavior gap.
The following value strategies will provide a framework for making your asset allocation investment decisions and avoiding many of the mistakes that create the behavior gap.
Asset Allocation Value Strategies
1. Time and Long Term Value Investing
In our fast paced world, with internet trading and instant gratification, it is popular to look for quick returns through schemes and strategies that carry undue risk. Benjamin Graham and Warren Buffett have taught the virtue of patience and the willingness to hold investments for long periods of time.
The markets will not always recognize the value in an investment immediately after your purchase. The idea is to buy at a price that makes waiting worthwhile.
2. Valuation Timing – Take Advantage of Mis-priced Markets
Graham used the parable of Mr. Market to illustrate the fact that investments are often mis-priced, sometimes overvalued, and other times undervalued. It makes sense to capitalize on mis-priced investments in order to increase your probability of making a profitable investment.
Valuation timing is the discipline of weighting your asset allocation based on valuation. Asset categories which are expensive should be avoided or underweighted, and categories that are bargains may deserve an overweighting.
3. Require a Margin of Safety
The core concept of margin of safety is: price matters! This may be the most important of all value strategies. The lower the price you pay, compared to the real value of the investment, the greater the probability that your investment will be profitable.
Purchasing investments at a deep discount reduces the risk of owning that asset. The margin of safety allows for problems, mistakes, or unforeseen disasters. Negative surprises may have less impact on an asset that is already priced low.
At the same time there is more upside to investments bought at a large discount to its real or intrinsic value. As time passes, eventually the market should realize the true value of the investment, and provide a sales price closer to that value. The larger the margin of safety the higher your probability of above average returns.
4. Portfolio Rebalancing & Weighting
Portfolio rebalancing is a risk management strategy in which you buy or sell investments to achieve your desired asset allocation percentage. As asset prices increase or decrease the total value will depart from your desired asset allocation target.
Portfolio rebalancing helps an investor to buy low and sell high. This is because the strategy involves achieving your target asset allocation by selling a portion of the assets that have risen in price and buying more of the assets that have fallen in price.
5. Capital Preservation
Preservation of capital should be an investors highest priority. Warren Buffett famously said “Rule # 1: Never Lose Money; Rule # 2: Never forget Rule #1.”
Related Reading: Portfolio Risk Control Strategies – Focus On What You Can Control
To be a successful investor you need to understand how compounding works for you and against you. If you lose 50% and gain 50%, you still have a 25% loss! These rules of mathematics make capital preservation extremely important.
Thinking Differently From the Crowd
Investors with the ability to develop patience and focus on value strategies will avoid investments at high prices when everyone else is bullish. However, when investments are being crushed by pessimism an astute value investor has the ability to snap up good values at bargain prices.
These 5 value strategies provide a foundation for making sound asset allocation decisions. Use the value strategies of time and long term investing, valuation timing, margin of safety, portfolio rebalancing, and capital preservation to lower your risk and improve your probability of above average returns.
Related Reading: Market Timing vs. Valuation Timing