For the long term investor, knowing how to increase or decrease the risk of his or her portfolio is a relatively easy task. If one wants to increase the level of risk one can simply increase the duration of the portfolio’s bond funds, switch assets from the fixed income portion of the portfolio to the equity portion, or overweight emerging markets equity funds. That is the easy part of the game. Knowing when to increase or decrease the risky assets in a portfolio is a more complex task.
At the risk of sounding redundant, the level of risk is generally determined by the investor’s risk aversion and, to a certain extent, by the age of the investor. We tend to consider, for example, that young people can take on more risk than old people, which in some way is a correct approach. The younger the investor, the more time he or she will have to recover from the potential drawdowns in his or her portfolio. Or, in other words, the longer the time period, the greater the probability the investment will end with a positive return. The problem with this approach is that ex-post we can find some periods where the investor (young or old) would have not obtained a satisfactory return for his or her investment. Let’s think for example of an investor who would have put all his/her money in the stock market at the beginning of 1965. They would have had a terrible return even after 15 years of investment (less than 2% per year in USD considering an investment in the S&P 500).
That being said, we have to recognise that diversifying the portfolio according to the age of the investor (allocating, for example, a percentage in fixed income equal to the age of the investor, a measure suggested by Vanguard founder Jack Bogle) is a relatively easy way to get reasonable returns over the long term. Intrinsically, using this system is also admitting that the asset allocation does not or should not depend on the market or macroeconomic conditions. But we also have to admit that if we look back at the market’s historical returns there are some points at which it was more attractive to invest in equities or points that were less risky to invest in stocks. The question is, how to identify those points? And the answer would be, by looking at valuations. This should not be a surprise. Several studies have demonstrated that the level of valuation at the point at which one invests determines in great part the long term return that one will obtain.
In the following graph we have compared the historical price/earnings ratio for the S&P 500 (the blue line, left hand scale) with the 10-years subsequent returns obtained by this index (the red line, right hand scale). For example, the last point in the graph represents the PE on August 2001 (around 32) and the return (0.9% annually in USD) achieved by the S&P 500 from August 2001 to August 2011. The PE we have used to construct this graph is the PE Shiller (calculated by Professor Peter Shiller), which is the price earnings ratio based on average inflation-adjusted earnings from the previous 10 years, data that is easily available for the particular investor (http://www.multpl.com/).
What is clear from this graph is that if one invests in equities at a point at which the PE ratio is high compared to the historical average, there is a high probability that the investor will end up with a below-average return over the subsequent decade. It is obviously not a perfect relationship but in the next graph, which charts another method of representing this relationship, we can see that in the past it has been practically impossible to get a 10-year double-digit return if one invested at the point when the PE ratio was above 20. One would also have had a poor return (below historical average) if the PE ratio was above 25.
This relationship, even if imperfect, gives us a practical way to overweight or underweight equities in a portfolio based on valuations, but it’s paramount that the investor has a very long term investment perspective.
