Adaptive Asset Allocation Policies

This article proposes an asset allocation policy that adapts to market movements by taking into account changes in the outstanding market values of major asset classes. Such a policy considers important information, reduces or avoids contrarian behavior, and can be followed by a majority of investors.Many institutional and individual investors adopt asset allocation policies that call for investing a specified percentage of the total value of a portfolio in each of several asset classes. To conform with such a policy as market values change requires selling assets that performed relatively well and buying those that performed relatively poorly. Such a strategy is clearly contrarian and can be followed by only a minority of investors. In practice, many investors seldom rebalance completely to conform with such a policy. But many multi-asset mutual funds, increasingly used in defined-contribution plans, do so frequently, which results in contrarian behavior.From January 1976 through June 2009, the ratio of the market value of U.S. stocks to the sum of the market values of U.S. stocks and bonds averaged 60.7 percent, close to the traditional 60/40 stock/bond mix. But during this period, the proportion in stocks ranged from slightly more than 43 percent to more than 75 percent. A fund that rebalanced its holdings frequently to a 60/40 mix would thus range from being considerably more risky than the U.S. bond and stock markets to being considerably less risky. If its goal was to represent the U.S. market of such instruments, it should instead have adjusted its asset allocation policy to reflect the relative values of the two asset classes.More generally, it seems appropriate for any fund to adapt its asset allocation policy from time to time in light of current relative market values of asset classes. This adaptation can be done by periodically conducting a reverse optimization analysis, in which current asset values are used to adjust asset risk and return forecasts, and then computing a new asset allocation by using these forecasts in an optimization analysis. This article proposes a much simpler approach in which an asset allocation policy adapts to market movements by taking into account changes in the outstanding market values of major asset classes. Such adaptive asset allocation policies consider important information, reduce or avoid contrarian behavior, and can be followed by a majority of investors.