Initial valuation affect asset allocation

[gpotter]

I've been thinking about this, and I'm not sure if I know the answer so I'm looking for the community to help. Does initial valuation of asset affect asset allocation and future performance? I understand that the goal of AA is to effectively buy low, sell high, but if stocks are valued so 'high' when I create my initial portfolio, will this affect my portfolio for its entire life?

Thanks!

[MustacheAndaHalf]

What you describe is a side effect - asset allocation is meant for managing risk.  The main decision is between stocks and bonds, where you decide your risk level using a certain percentage of bonds.  Someone near retirement might have 50% bonds, while someone still accumulating might have 10-20% bonds.  As you approach retirement, big downward swings can permanently change your retirement plans, so you shift towards bonds.

A side effect of keeping stocks and bonds in fixed percentages is that you sell stocks when they grow faster, and buy bonds when they grow slower (or the reverse).  But that's not the primary goal of asset allocation - it's limiting your risk by having a percentage in bonds.

[Cannot Wait!]

Mustacheandahalf,  wouldn't you also want to balance between international and domestic allocations of ETFs? As well as between bonds and equities?   

[Tyler]

I've been thinking about this, and I'm not sure if I know the answer so I'm looking for the community to help. Does initial valuation of asset affect asset allocation and future performance? I understand that the goal of AA is to effectively buy low, sell high, but if stocks are valued so 'high' when I create my initial portfolio, will this affect my portfolio for its entire life?

Thanks!

Yes, there's good research to show that valuation matters to future returns.  But it's more important to value strategies than to diverse asset allocation strategies.

If you're overly concentrated in any one asset (or index), then yes your portfolio may be more sensitive to start date luck than you'd like.  A truly diverse portfolio, however, will include some things that are currently valued very highly and others that are doing relatively poorly, and the timing of buying the portfolio as a whole is less important.  This article should give you flavor for how this works and help you quantify the sensitivity of a particular portfolio option to timing risk. 

[MustacheAndaHalf]

Cannot Wait - My answer aims to clear up OP's confusion around asset allocation, and keep the example simple.  But you or others could do well with a three fund portfolio that includes total US stock market, total international stock, and total bond market.  If OP is comfortable with the discussion so far, I'd extend asset allocation to international vs domestic.  But first, OP needs to be clear about the purpose of asset allocation, how bond percentage changes with age / risk, and the decision about percentage bonds.

[gpotter]

Mustacheandahalf - I'm comfortable with the discussion so far. I understand that there are multiple purposes for AA, such as having a plan that takes the emotion out of investing and forces you to keep things balanced regardless of how the market is reacting.

If I start a portfolio today with $100,000 and split it 60/40 stocks/bonds. Stocks are trading at a Shiller P/E of 26, so pretty expensive, but not insane. Will this portfolio expect to yield the same 9% avg return over 30 years as a portfolio that starts with a Shiller P/E of 16 (median value)?

[Proud Foot]

If I start a portfolio today with $100,000 and split it 60/40 stocks/bonds. Stocks are trading at a Shiller P/E of 26, so pretty expensive, but not insane. Will this portfolio expect to yield the same 9% avg return over 30 years as a portfolio that starts with a Shiller P/E of 16 (median value)?

The portfolio starting at a P/E of 26 would expect to have a lower return than starting at a P/E of 16. However this applies more to the purchase of individual stocks than investing in a mutual fund.  If you are buying a broad market fund (VTSAX) you will be buying stocks with a varying  P/E from being very high to very low.  When you are purchasing into a mutual fund and are consistently making contributions then you will not be purchasing at a consistent market average P/E. When purchasing like this, the time in the fund has more of an effect on the performance than the P/E at time of purchase. 

[AdrianC]

If I start a portfolio today with $100,000 and split it 60/40 stocks/bonds. Stocks are trading at a Shiller P/E of 26, so pretty expensive, but not insane. Will this portfolio expect to yield the same 9% avg return over 30 years as a portfolio that starts with a Shiller P/E of 16 (median value)?

Almost certainly not. Over the long term:

Stocks: dividend yield 2% + 5% growth (optimistic)
Bonds: 2%
60/40: 5%

Stocks: dividend yield 2% + 3% growth (realistic)
Bonds: 2%
60/40: 4%

So 4 to 5% assuming no change in valuation, and from a CAPE of 26 valuation is more likely to go down than up.

But...what's the alternative...market timing? ;-)

[Radagast]

I've been thinking about this, and I'm not sure if I know the answer so I'm looking for the community to help. Does initial valuation of asset affect asset allocation and future performance? I understand that the goal of AA is to effectively buy low, sell high, but if stocks are valued so 'high' when I create my initial portfolio, will this affect my portfolio for its entire life?

Thanks!

Basically, yes. However, presumably you will be making regular contributions over the course of at least a decade, so hopefully you will have plenty of opportunities to buy low. But you never know, perhaps the next ten years will run up to a huge stock bubble, meaning right now is the lowest price you ever get to buy at. Then the bubble pops right after you retire. That is why diversify diversify.