I find it’s important to make any allocation decision in a larger perspective, that is systematically, rather than treat each situation as a one-off. For example, when deciding what to do about the current period of rising rates it may be instructive to consider that since the end of the GFC we have gone through about 10 rate / inflation panics, all of which ended up with lower rates and lower inflation. This doesn’t mean that this latest bout is going to end up the same way since every situation is different but, rather, that we have seen periods of rising rates before and sharply reversing allocations after a rate run-up is not a strategy that has worked either consistently or at all.
An allocation style that investors in income markets may also want to avoid is shifting allocations in a binary fashion, that is, either all-in or all-out. In a taxable account this style of investing raises the bar for being correct given the tax impact. However, even in tax-sheltered accounts there are slippage costs as well. Beyond these two drags, avoiding binary allocations recognizes the uncertainty of the environment that investors operate in and the duration of trends. For example, valuations that seem on the expensive side can remain expensive for a long period of time, creating significant opportunity costs for investors on the sidelines. Avoiding binary allocations create a smaller risk of being wrong – an investor who pares risk back as valuations grow more expensive will continue to participate in any potential uptrend or stable market environment which minimizes regret and decreases the risk of getting back in much closer to the top, having missed the bulk of the move higher. In case markets do sell off, investors can draw on the dry powder allocation that has, hopefully, been growing over time as valuations richened which can now be put to work. Investors who were all-in at the top will find it difficult to take advantage of improved opportunities.
An important question to ask is what kind of assets are we allocating to? Are we in a, fundamentally, trending asset, such as stocks, or are we in broadly mean-reverting asset, such as credit. The nature of the underlying asset we are holding can further inform the approach to allocation. Trending assets can have much wider trading ranges, can trend for longer periods and can have harder-to-gauge measures of values. This makes it more difficult, though not impossible, to allocate to such assets based on indicators of value. However, allocating to fixed-income with a value mean-reverting approach is less difficult as measures of value (nominal and real rates, credit spreads, yield curve, inflation risk premium) are much more clear-cut with ranges that are not particularly wide. The upshot here is that buying credit when credit is cheap and vice-versa hA, historically, shown to be a pretty robust allocation approach.
Finally, as I’ve mentioned in the Morning Note, nothing beats conviction. And though it’s important not to be overly dogmatic about conviction (the market can remain irrational longer than we can remain solvent, as the saying goes), it certainly helps to stick with a well-thought out plan. This can take the form of an allocation schedule based on the level of underlying assets. So, for instance, being able to spend down your dry powder all the way through high-yield corporate yields moving from the current level to around 10% where they have tended to top out, with the exception of the GFC. This top range will be different for everyone, of course – more aggressive allocators will want to spend their dry powder earlier and may likely have a smaller reserve in the first place and vice-versa. And obviously, this requires there to be a dry powder allocation. This doesn’t have to take the form of cash – it just has to be in assets that will see a lower drawdown than the assets that you want to invest in. So, for some, their dry powder allocation will be short-dated credit that had a single-digit drawdown in 2020 or it could be short-dated HY with a 20% drawdown.
Ultimately, having a plan of how to respond to changing prices is important as it avoids impulsive decisions and trading based on fear and System 1 thinking.
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