Sunday, February 18, 2007

Asset allocation clock: asset allocation for market timing

Many years ago my full-service broker's firm would send out a monthly newsletter that contained a continuously updated view of the firm's recommended client asset allocation model, namely, how to proportion your financial assets between the three main asset classes of cash, bonds, and stocks. How the model was updated was always a mystery. And, it was never clear if following the model ever worked for anything other than to increase trading and cause you to pay more commissions.

Not too many years ago (maybe back in 1999 or 2000), I was leafing through a zillion finance books at Barnes & Noble and stumbled across something called the asset allocation clock which purported to show you how to expand and shrink your asset class allocations at different stages of the traditional business cycle. It wasn't a precise mathematical model for asset class allocation, but did show which asset classes would be in favor and which would be falling from favor at each stage. In essence, it was a grand attempt at a unified approach to market timing. Again, I do not know how well it works, if at all. But, at least it resolves the mystery about the basis for those mysterious monthly updates from my old brokerage firm.

Each firm has their own proprietary asset allocation models and proprietary processes for updating them and not all firms agree on even the time of day for their asset allocation clocks (i.e., precisely where we are in the business cycle). Further, these models seem less in favor in recent years. A few years ago I recall frequent news items about various firms raising or lowering their equity and cash allocations. These days, the term asset allocation model is not used as frequently and tends to refer simply to your current proportion of various asset classes, without regard to what principles guided the selection of the model. And even the term asset class is more loosely used to refer to domestic versus international and regional stocks and bonds, and even individual countries.

The real catch with these asset allocation clocks and their implied asset allocation models is that it is very difficult, if not impossible to judge what "time" it is on the clock. There is no shortage of people who claim that they "know" what time it is, but there is very little agreement between many of them, other than in various "camps" or "factions", and even then there is some degree of disagreement. Further, some people may attempt to jump the gun and pre-position themselves in anticipation that others will in fact jump in and out of asset positions precisely as dictated by the clock.

I wish I could remember which book I saw it in. In fact, I saw it in two different books.

Later when I search the Web, I could find very few references to asset allocation clock. One of them being my own description. Here the main diagram that I found that seemed to convey the essence of what I had seen in those books years ago:

As you can see, the original source was Merrill Lynch. My source on the Web no longer exists. Luckily, I saved a copy of the clock image. Here is another variation of the asset allocation clock which I found on the Web:

A more traditional and simpler asset allocation "clock" is that which Ben Graham proposed in The Intelligent Investor, which simply had a rough 60/40 split between stocks and bonds. When stocks appeared to be relatively overvalued, you would go an overweight 60% stocks and underweight 40% stocks, and when bonds appeared to be relatively overvalued, you would go an overweight 60% stocks and underweight 40% bonds, and then slide between those two extremes as relative values shifted over time.

In summary, I am not advocating outright market timing, but it would be instructive to contrast the principles that you currently use to drive your asset allocation models with these traditional approaches. Just because an approach is newer doesn't mean that it is better.

-- Jack Krupansky

1 Comments:

At 3:02 AM EDT , Anonymous Term papers said...

good collection ... nice one .

 

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