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Allocate by Market Weight (And Adjust for Personal Circumstances)

Charles Rotblut (CR): I’d like to discuss allocation, starting with rebalancing. A lot of people either psychologically have a problem doing it or just won’t do it. What are your thoughts?

William Sharpe (WS): I think, by and large, people probably shouldn’t do it. In particular, rebalancing by selling winners and buying losers. Basically, if you’re going to sell your winners and buy your losers, then you have to trade with someone. And that person has to take the other side of the trades. If you’re smart doing that, then the other person must be dumb to trade with you. So the questions are: Why is that a good thing to do, and what’s the matter with the other person for trading with you?

We can’t all rebalance, because rebalancing to pre-selected proportions means selling relative winners and buying relative losers. Since we can’t all do that, the question is: If this is the obvious thing to do, with whom are you going to trade? Who is it? And why should the other person trade with you? In an efficient, sensible or informed market, such rebalancing will not be a good strategy.

I would like to see a very-low-cost index fund that buys proportionate shares of all the traded stocks and bonds in the world. Unfortunately, there are none at present. It would be good if there were one or more used by a great many investors as their main investment vehicle. While such a fund is not available, you can construct one from existing index funds, but then you have to monitor the current world values of the components—for example, the value of all the U.S. bonds for the U.S. bond index fund, the value of all the non-U.S. bonds for that fund and the value of all the world stocks for that fund. I’ve talked to my friends in the index fund business, and thus far nobody seems to be interested in producing that. It is a huge hole and individual investors could really use such a fund.

CR: What about adaptive allocation? I know you’ve written about the subject.

WS: Here is a simple way to think about this. Assume that at the moment stock values are 60% of the total value of bonds and stocks, that bond values are 40% and that you just want to have the risk and return of the average investor. Then you should invest 60% in stocks, 40% in bonds. And now, let’s say, stocks go up and bonds go down, so the market values are now 70%/30%. If you want to continue to be the average investor, you should have 70%/30% proportions. But when you look at your portfolio values, you are likely to find that they are already close to 70%/30%. And you didn’t have to do anything. This won’t be exactly the case due to new security issues and things of that sort, so you might have make some minor adjustments, probably when reinvesting dividends and bond payments. But the trades will be small. The idea is to have a policy that indicates what proportions you want when the market proportions are, say 60%/40%, and then keep your relative risk constant as market values change (Figure 1). The formula that I suggest for adaptive asset allocation works from this basic policy and indicates the proportions that you should have as market proportions change.

In the simplest case where you just want to take the risk of the average investor, the formula just says that your policy should be to hold the same proportions as the market. If you want to have a policy of being more risky than the average investor, then you have to look at the formula. But it’s a very easy formula.

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Figure 1. How Adaptive Allocation Works


 

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