As the chart shows, the NAAIM equity exposure index has swung wildly from under 20% to over 80% in the past four years. These kind of volatility is more consistent with panic and euphoria of swing traders or reflect the risk tolerance of hedge funds than plain vanilla individual investor investment mandates.
Most professional investors would have a process where they establish an investment objective for their client, with an asset allocation benchmark, e.g. 50% stocks, 50% bonds. They would then vary their exposure by 5-10% around that benchmark. Under extreme market conditions, a typical target variance from benchmark might be 20% from policy weight.
So how does the NAAIM sample have such wild swings?
Questions for your manager
If I were an individual investor entrusting my money to a discretionary RIA, which is the NAAIM membership is drawn from, I would ask the following questions, which would be entirely appropriate as discretionary managers are held to a fiduciary standard:
- As you have assessed my personal financial objectives, what do you consider to be my proper policy weight?
- How much variation would you tolerate from policy weight as an active decision?
- What is your re-balancing process? How often do you re-balance and what kinds of events would cause you to re-balance the portfolio?
The wild variation of the NAAIM survey sample can be explained in two ways. First, it could be the result of passive drift. In a raging bull market, equity weights could creep up to a level way beyond target weight. Conversely, in a devastating bear market, equity weights could plummet to extremely low levels.
As well, the swings in NAAIM equity weights could be the result of active decisions by the managers to buy or sell equities. However, it is hard for me to comprehend that in the space of last few weeks that the NAAIM managers panicked and sold their equity positions down to historically low levels and then panicked again to buy back into the stock market. Do they have a process, or are they just flying by the seat of their pants?
What is the re-balancing process?
For well constructed balanced portfolios. the last round of stock market weakness should not have been a disaster. US large caps, as measured by the SP 500, down about 10% peak-to-trough and small caps seeing a substantially higher draw-down, but the bond market rally has offset much of those losses.
A saner question might be: Once you've established a policy or target weight, when should you re-balance your portfolio?
Regardless of what path you or your investment manager chooses to create a portfolio re-balancing process, make sure that there is a process, rather than the apparent seat-of-the-pants approach shown by the NAAIM survey sample. In a future post, I will discuss different ways of re-balancing portfolios - sort of a "re-balancing your portfolio for fun and profit" post.