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Benjamin Graham on Asset Allocation

The majority of mainstream financial literature advocates an asset allocation strategy that accounts for neither interest rates nor market valuation levels. (The most common suggestion being the “age in bonds” rule of thumb.)

But common sense tells us that, all else being equal, the stock market is a better buy when it has a P/E ratio of 12 than when it has a P/E of 18. Similarly, all else being equal, it’s better to buy a given bond index fund when it’s yielding 5% than when it’s yielding 3%.

So how might one go about capitalizing on such fluctuations?

Benjamin Graham, author of The Intelligent Investor (probably the most-respected investment book ever written), has one suggestion. He advocates:

  • Using a 50/50 stock/bond allocation as a baseline, and
  • Shifting as far as 25/75 in either direction, based upon current market conditions.

Graham explains it this way:

“The sound reason for increasing the percentage in common stocks [beyond 50%] would be the appearance of ‘bargain price’ levels created in a protracted bear market. Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgment of the investor the market level has become dangerously high.”

Seems reasonable to me.

Implementing Graham’s Suggestions

The tricky part is the actual implementation. For example:

  • What, exactly, constitutes “bargain price” levels? And what price level would be “dangerously high”?
  • How often should you check market valuations to see whether you should adjust your current allocation?
  • To what extent should you shift your allocation based on a given degree of change in market valuations?

Bob Davis, one of the authors of The Bogleheads’ Guide to Retirement Planning, provides one method. He suggests comparing the current earnings yield of the stock market to the current yield on the bond portion of your portfolio — keeping a 50/50 allocation when the two yields are the same, and shifting slightly toward whichever yield is higher when they’re unequal.

Another Boglehead author, The Finance Buff, follows a plan of “overbalancing.” That is, rather than periodically rebalancing to a target asset allocation, he rebalances beyond his baseline allocation based on changes in market valuations.

Why Not Use Such a Strategy?

Given the common-sense appeal of accounting for price levels and interest rates when investing, why would you not want to implement such a strategy? I can think of four reasons.

First, as Graham puts it, “A program of [this] kind is not especially complicated; the hard part is to adopt it and to stick to it.”

It’s hard to move to a particularly stock heavy allocation right when the strategy calls for it (i.e., right after a market crash — when the economy looks the bleakest). And it’s hard to move money out of stocks right when they’re performing their best.

Second, while such a strategy isn’t particularly laborious to implement, it’s certainly more work than rebalancing once each year to a given asset allocation.

Third, once you’ve decided that you’re more clever than the market in one area (overall valuations, in this case), it’s tempting to start thinking you’re more clever in other ways as well. This can be dangerous. While the market’s not perfect, it’s a lot smarter than it looks.

Finally, there’s the simple fact that you might be wrong. While the market may look underpriced at a given price level, it’s entirely possible that it will continue to go down, for reasons you could not have predicted. And, therefore, moving a greater percentage of your portfolio into stocks would turn out to be a mistake. (And, of course, an opposite mistake can occur when deciding the market is overpriced at a given point in time.)

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  1. >Second, while such a strategy isn’t particularly laborious to implement, it’s >certainly more work than rebalancing once each year to a given asset >allocation.


    I guess the amount of work depends on how volatile the market is-the last few years would have required a lot of work! However, the strategy forces you track the market & interest rates to know when to act. Is it worth the extra work? Without a comparison of how Graham’s strategy compares to periodic rebalancing using historical data (including transaction costs!), we are just guessing if it’s a better strategy.

    -Rick Francis

  2. As you say – it looks easy but it is difficult in practice. I asked people 2 years ago why they weren’t in bonds and instead were in cash. At the time the 10 year Treasury yield was 4%. They said yields were too low and when they hit 5% on the 10 year Treasury they would buy bonds.
    Today the yield is 2.70%. I guess they are still waiting and in the interim have missed an enormous rally.
    This is the bond side of what you showed on the stock side. Buy when prices are low and sell when they are high. Alas, if only somebody would ring a bell and let us know when that is.

  3. I certainly won’t disagree with anything Graham says. But, I might disagree (a tiny bit) with your statement that most asset allocations don’t consider valuations. Actually, the act of rebalancing your portfolio back to the desired asset allocation automatically guarantees that you sell some shares of the higher value assets and increase your position in the lower valued ones. It’s kind of like automatically sellling high and buying low. Good article!

  4. I think a lot depends on whether you choose to rebalance on a fixed schedule or when your target allocation is thrown off by a certain percentage. I’ve heard it argued both ways. But another issue that doesn’t seem covered in your article is adjusting allocations by age. Would Graham advocate a 50-50% base split for someone who’s 25 or for that matter someone who’s 70?

  5. Correct me if I’m wrong, but this article sounds like market timing and I thought the oblivious investor does not engage in market timing?

  6. I have been thinking of this Graham suggestion a lot [and after reading about 100 books on investing in the past 4 years, including Bernstein, Ferri, Ellis, Swensen, Malkiel, and Roger Gibson on asset allocation].
    It seems at first very simplistic, but I think [because it is based on Graham’s lifetime of experience] it is really actually sophisticated.

    I’m not sure I trust Wall Street, or believe in the Academic theories either,
    but after the past couple years and in the current markets 50/50 looks pretty safe/conservative to me, with small adjustment according to your age, values, or whatever you believe in, but not too often, and not too far off the Graham suggested ranges.

    Is style investing more than fashion? Do market segments always return to mean? I don’t know, maybe it is all random, or too complex to figure out, or maybe the 80 years of fairly good data on investing are insufficient!

    Stick with worrying about the stuff you CAN control, like costs.

    Do not forget: The conventional wisdom was really wrong on stocks in March 2009, and again on bonds in January 2010.

  7. In The Intelligent Investor at least, Graham doesn’t indicate that age would play any role in the asset allocation decision. He does say, however, that an investor’s ideal allocation “may well rest mainly on his own temperament and attitude.”

  8. “Without a comparison of how Graham’s strategy compares to periodic rebalancing using historical data (including transaction costs!), we are just guessing if it’s a better strategy. “

    Well, it wouldn’t be terribly hard to put together such a comparison. (Though first you’d have to select answers to all the above questions that Graham leaves unanswered.) If you follow the link above to the Bogleheads thread discussing Bob Davis’ particular implementation, you can see the results he’s calculated.

    Still though, even with such data, there’s a lot of uncertainty left as to how any particular strategy will perform in the future!

  9. I am so happy to see some intelligent discussion on this point. I have been ruminating on it for the last nine months. My eventual goal is 50/50 stocks to bonds. Currently, I am 100% stocks only b/c bonds have appreciated so much they are clearly not a good value. I also buy monthly and rebalance my funds with the new money. That said, if I had been 50/50 stocks to bonds at the market bottom in March 2009, then my stock allocation would have been grown considerably and I should have in theory been buying bonds to come back to 50/50. At that same time due to the amount of skepticism in the market, bonds prices were appreciating. This all leads me to believe that 50/50 is a good goal, but buying and rebalancing monthly may not be the right thing to do through out the market cycle. As for me, I am about ready to stop buying stocks and save my money for bear bond market to come. Also @DIY investor – great comment on people waiting for the 5% yield in bonds that never came. Who would have ever known?

  10. I’m reading the Intelligent Investor right now (I know, I should have read it before I started investing) and I do like their approach on 50/50 bonds and stocks.

    I would say right now, I’m at about 30% bonds and 70% stocks. But then I have a lot in cash too.

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