Tuesday, March 3, 2009

Market timers vs. asset allocators

Modern Portfolio Theory tells us to hold a balanced portfolio of stocks and bonds. If we want higher returns, we have to increase the portion of our portfolios devoted to risky stocks.

Jeremy Siegel takes this argument one step further and notes that if you have a longer time horizon, e.g., 20 years, there is no tradeoff between risk and return: holding bonds serves only to reduce return:
Stocks on the long term have returned 6.8% per year after inflation, whereas gold has returned -0.4% (i.e. failed to keep up with inflation) and bonds have returned 1.7%. The equity risk premium (excess return of stocks over bonds) has ranged between 0 to 11%, it was 3% in 2001[8]also.
John Mauldin has a good column on the revenge of the market timers. He shows, in the table below, that it matters when you get into the market.

The implied prescription is to look at market fundamentals and enter the market only when stocks are relatively cheap (as Shiller's methodology currently says it is).

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