jester
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Post by jester on Jun 24, 2023 19:33:55 GMT
I have always had a buy low cost All World Tracker mindset, hold them indefinitely and take what comes. I don't try to time the market, other than buying in more heavily than my usual after the previous banking crash! However recently I'm wondering if it's wise to hold 70% equity exposure and whether the markets are running hot given the inflations issues and rate rises. I came across this article seekingalpha.com/article/4509235-with-the-s-and-p-500-plunging-should-you-go-to-cashwhich contains a formula as guidance for increasing or reducing equity exposure. Equity Allocation = Expected Return - Cash Rate / Standard Deviation^2 Does anyone use anything like this or purely make adjustments on the fundamentals? |
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Post by Ace on Jun 24, 2023 19:53:07 GMT
I clicked on the link, but it wanted me to sign up, which I couldn't be bothered to do. So, I can't be sure of the definition of the terms in the equation. However...
There's no magic formula. How much you should hold in Equities will depend on many factors which are personal to you, none of which appear to be contained within the terms of the stated equation.
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jester
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Post by jester on Jun 24, 2023 20:51:37 GMT
I agree, my equity exposure is based on my age, years to retirement, risk tolerance, pension expectations etc. Plenty of criteria!
However none take any account for reducing or increasing exposure due to market conditions which this attempts to assist with.
It's long term expected return eg. 7.9% stated for S&P500 minus current cash return rate eg. 5%
Divided by square of volatility/standard deviation, they quote VIX 20% as example for this.
Eg. (0.079-0.05)/0.2^2 = 72.5% equity
It does say it's not a precision tool, but an indicator eg over 100% suggests increase or low percentage suggests reduce.
Probably far from perfect but I don't know what else to look at and consider when it comes to adjusting for market conditions!
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Post by Ace on Jun 24, 2023 22:05:14 GMT
OK, I sort of get it, but just feels like another way to try to time the market. Most who invest significant sums in global trackers have already come to the conclusion that that is not something they are likely to win at, so base their percentage of equities on their personal factors and adjust only when those factors change.
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Post by bernythedolt on Jun 24, 2023 22:48:46 GMT
jester, fascinating stuff, I've certainly never come across this before. Note you ought to place brackets around the (Expected Return - Cash Rate) term in your original post. Since Standard Deviation squared is equivalent to the Variance in a dataset, the denominator in the formula is certainly a measure of spread or turmoil (for want of a better word!) in the system. Here they are using volatility squared as the measure of variance, which seems intuitively fair. Since the long-term volatility of the S&P500 (and, as far as I can see, the FTSE 100 also) generally seems to fall around the 20% mark, this variance can pretty much be thought of as the constant 0.04 (being 20% squared). Dividing by 0.04 equates to multiplying by 25. So we're left with Equity Allocation being some multiple of (Expected stock market Return - bank Cash Rate on offer), where the multiple is probably best thought of as 25 most of the time. For me, this now passes the basic sniff test, because it at least matches up reasonably well with common sense. When the stock market offers 4% and the banks offer ~zero, the formula returns the figure (4 - 0)*25 = 100% allocation to equities, which seems reasonable enough. When the stock market offers 5% and the banks also offer 5%, (5 - 5)*25 = 0 suggests stick it all in the bank, again perfectly sensible. Where the stock market return exceeds the bank by 2%, split your funds 50:50, when it exceeds it by 3%, split 75:25, and so on. Nothing there seems too unreasonable. So at face value, the formula seems a reasonable steer. My two concerns would be:- 1. How frequently do you need to react to changes in the volatility index? Too frequently and you will be forever trading; infrequently and you may as well ignore the denominator and treat it as a constant as I have above. 2. And this is the showstopper for me.... how do you ever enumerate the 'Expected stock market Return'? This part requires a crystal ball! So we're back to good old-fashioned guesswork and wet finger in the air... 'twas ever thus! So, in summary, the formula looks reasonably sound to this particular investment layman, but in practice it offers very little more than pure common sense. If you see a widening of the gap between stock market return and bank rates, stick correspondingly more into stocks and if you see the gap closing, reduce your equity holding and stick it in the bank instead.
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jester
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Post by jester on Jun 25, 2023 20:27:59 GMT
bernythedolt I appreciate the detailed assessment, broken it down better than I ever would have! The article itself suggests Some traders think that trying to estimate returns is problematic, so they just target volatility at a constant level. This is easier to do and was how I ran the backtest from above. So perhaps constantly adjusting the portfolio based on a predicted volatility is a step too far.
I agree that any form of predicting the stock market or outperforming doesn't rest easily with my investing outlook, however I wonder if there is common sense in risk adjustment in times when average stock market performance and cash rates come close.
It's certainly got me thinking that it might be worth reducing my equity exposure now with cash rates of 5% on offer.
The formula for what it's worth suggests (0.079-0.05)/0.04 given average volatility = 0.725
I currently have zero cash, I could consider moving 25% of equities into cash as capital preservation!
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Post by bernythedolt on Jun 25, 2023 22:01:28 GMT
bernythedolt I appreciate the detailed assessment, broken it down better than I ever would have! The article itself suggests Some traders think that trying to estimate returns is problematic, so they just target volatility at a constant level. This is easier to do and was how I ran the backtest from above. So perhaps constantly adjusting the portfolio based on a predicted volatility is a step too far.
Or using my method, 7.9% predicted stock market return less 5% bank return gives 2.9%, multiplied by 25 to give 72.5% to put into equities, the rest into the bank. Same result obviously, but possibly slightly more intuitive to work with the percentages directly? Speaking for myself, there surely has to be. Why would you place your capital at risk in a stock market for the same, or almost the same, return as the guaranteed interest from an FSCS-protected bank/building society/cash ISA account? 5.76% is available now, on a 1yr fix. I agree and am slightly ahead of you, having already switched a chunk of equities into cash this past year, with more to follow as rates are improving and (it seems to me) the stock market, after fees, is performing little better than a cash account right now, if that. Why risk sleepless nights when you could sleep soundly for a similar return? For capital preservation, I believe the advice is zero cash is a risky strategy, even in the best of times. Even the most adventurous types are recommended to keep back at least a few % in cash, (according to Which? magazine some years ago anyway!). With returns as they are right now, and as a pensioner, I am comfortable being 75% (and slowly increasing) in cash and 25% (and slowly reducing) in equities. Obviously at a younger age, your goals and risk appetite will be different to mine though. Usual disclaimer applies: please do your own research and don't take my personal opinions or anything I've said as advice of any kind.
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Post by Ace on Jun 25, 2023 23:28:40 GMT
As I see it, the fatal assumption in the equation is that the guess at future equity returns (Expected Return) is correct and linear.
In reality, even if the guess at 7.9% is correct over the long term it's incredibly unlikely to be correct in the short term. Equity returns will be made up of good, bad and average years with absolutely no way to know which is next. It might be up 30% next year, down 20%, completely flat, or any other number you can think of. Most equity gains will be made in the few very good years. If you miss out on one of these years you won't get anywhere near that, correctly guessed, long term average.
If cash rates rise and you switch a portion of your equities out for a year, then switch them back in due to cash rates falling a year later, you've no way of knowing what type of equity performance you are going to miss out on. It almost certainly won't be a perfectly average 7.9% year.
I maintain that following this equation (or any other for that matter) is just another way of trying to time the market.
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jester
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Post by jester on Jun 26, 2023 8:38:02 GMT
bernythedolt 5.76% narrows the field even further, although I need to keep funds ISA wrapped so 5% is the best available to me and the BOE Base so I stuck to that for the calculation! As for my cash situation, I realise 0% isn't necessarily advised but I made the decision based on my partner wishing to keep her savings as cash so I figured I could be more liberal with mine. At the moment I am: 70% Equities (All World Trackers) 10% Property REITS / London House Exchange 10% P2P 10% Crypto Ace I tend to agree it looks like timing the market, my thought process is more about portfolio structure overall and not about outperforming the equity market This formula for what it's worth (maybe nothing) just got me thinking that when interest rates are this high it might be sound thinking to reduce equity exposure to preserve additional capital in cash, which I'd be happy to throw back in if we do get a significant crash in the stock market. Worst case I suppose is I make gains, but they are lower gains .... I can probably live with that as the downside!
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Post by mostlywrong on Jun 26, 2023 10:52:40 GMT
Thank you for the discussion and the formula.
Interesting stuff.
I try to keep cash at around 10% in both my ISA and SIPP, just in case there is an opportunity. The rest is in global unit trusts and ETFs.
I am less disciplined with my trading account where cash rises and falls as and when I trade.
MW
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mogish
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Post by mogish on Jun 26, 2023 12:02:53 GMT
Just sold my (small) holding in both fidelity emerging markets and premier miton uk smaller cos.
It's ok looking at fancy graphs and 10 year promises of returns but currently cash is actual and less volatile.
The lot went into rl short term MM.
Whether this is right or wrong who knows.
If I can get 4 to 5% with low risk
or a promise of potential growth I know which one I now want.
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Post by mostlywrong on Jun 26, 2023 13:07:16 GMT
As a result of the press coverage last week, I looked at Gilts over the weekend.
Top of the list was TY25 - a Treasury which yields 3.5% and matures (£100) in Oct 25.
Its dirty price is £96.41 which includes the interest that has accrued.
Sharepad reckons its yield to redemption is 5.48% pa.
Better than cash. The risk to both is inflation. 
MW
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Post by bernythedolt on Jun 26, 2023 15:23:26 GMT
As a result of the press coverage last week, I looked at Gilts over the weekend.
Top of the list was TY25 - a Treasury which yields 3.5% and matures (£100) in Oct 25.
Its dirty price is £96.41 which includes the interest that has accrued.
Sharepad reckons its yield to redemption is 5.48% pa.
Better than cash. The risk to both is inflation.
MW
Is it better than cash though? Two-and-a-bit years to run at 5.48% yield, versus 5.76% interest currently on offer in a two year fixed cash account.
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Post by mostlywrong on Jun 26, 2023 15:33:08 GMT
As a result of the press coverage last week, I looked at Gilts over the weekend.
Top of the list was TY25 - a Treasury which yields 3.5% and matures (£100) in Oct 25.
Its dirty price is £96.41 which includes the interest that has accrued.
Sharepad reckons its yield to redemption is 5.48% pa.
Better than cash. The risk to both is inflation.
MW
Is it better than cash though? Two-and-a-bit years to run at 5.48% yield, versus 5.76% interest currently on offer in a two year fixed cash account. I was thinking in terms of an investment account but, yes, your offer is better.
MW
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jester
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Post by jester on Jun 26, 2023 20:42:33 GMT
mogish I'm afraid I have no idea what this means "rl short term MM" but I'd most likely just be investing in fixed rate cash offerings from the banks. I think tomorrow I might pull some equities back into cash, I've talked myself into it! Another question for everyone on the topic, do you have a go to source for macro market analysis or do you just keep it simple and avoid the expert analysis!
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