A simple strategy prescribed by the father of value investing works most effectively with religious application
Nearly 70 years after the publication of The Intelligent Investor, many of the value investing principles laid out by Benjamin Graham remain useful for defensive portfolio allocation. Among those is the importance of sticking to one simple yet critical decision: asset allocation.
“In theory the split [between stocks and bonds] depends on expected returns, volatility (how much asset prices fluctuate), the investor’s appetite for such volatility—and even the investor’s age and job,” according to a recent article on The Economist. “Thankfully Graham had a simpler answer: a 50-50 split between stocks and bonds, maintained by adjusting as required by market prices.”
The beauty of the approach, the article explained, lies in simplicity. While index funds have made it easier than ever to be a defensive investor, they haven’t eliminated the need for investors to decide how to diversify between asset classes. While the portfolio weightings matter, sticking to the weightings is more important — and that requires regular rebalancing.
“If stockmarkets boom while bond prices drift, a 50-50 split can quickly become 70-30,” the article explained. “A timely rebalancing would mean selling shares and buying bonds to restore parity.”
By rebalancing, an investor also takes changing valuations into account. The strategy lets them shed higher-priced assets in favor of cheap ones, which effectively amounts to quitting while they’re ahead. The approach is a long-term one, as opposed to the short-term directional philosophy of “cutting your losses and letting your winners ride” favoured by some hedge-fund traders.
The importance of regular rebalancing was highlighted by Andrew Ang of BlackRock, who drew on US stocks and bonds returns data from 1926 to 1940. At the end of the period, he said, a US$1 investment following a 60-40 split between stocks and bonds would have been worth US$1.92 if left untouched. US$1 invested solely in stocks during the period would have been worth US$1.81 by the end of 1940; put it solely in bonds, and it would have a final value of US$2.08.
With quarterly rebalancing, however, a 60-40 portfolio portfolio initially worth US$1 would end the 15-year period with a value of US$2.46.
“This is not an easy policy to follow. It goes against instinct to buy assets that have fallen heavily in price,” the article noted. “But having a clear and simple strategy helps. … If a rebalancing habit is established in calm markets, it will be much easier to follow when markets become stormy.”