Equity Allocation Calculation

nirish

JohnWinder said:

‘However for me using Vanguard Global All Cap I get (7.9-5 / 0.14^2)=148%

Can anyone savier than me workout what I'm doing wrong here as I love the concept of guidance in reducing equity exposure.’ .

Easy, it’s not 7.5-5, it’s 7.9%-5%. 

Thanks for the link to the formula. There is no explanation about how the formula was developed, how it’s been tested or any validation of it. Have you followed up the link to an earlier use of the formula, and can you tell us what you’ve found to give the formula some credibility? 

The formula has ‘standard deviation’ squared which is a measure based on history. He seems to use the VIX index which is a market anticipation of volatility, expressed as a percentage although the index is not a percentage.

How much, %/year, should we expect our portfolios to outperform a ‘buy and hold’ approach, and what might be the variation in that outperformance if we use his formula? There might be costs associated with his approach: trading costs, buy/sell spreads, capital gains tax etc; we’d want it to be worth the costs.

If it worked well enough there’d be fund managers using it, you would imagine, enabling them to offer guaranteed outperformance compared with ‘buy and hold’. Anyone offering that?

You may have sensed I’m sceptical.

Ok, just to add a little context.  I am and always have been a low cost, buy and hold all world tracker type investor.  I don't chase outperformance and mad ideas as a rule .... I'm just wondering with all that's going on in the worldwide markets whether it would actually be wise to reduce my high equity exposure.

Having said that, while trying to research I found this article and found the concept of a formula to assist with the decision an interesting one .... I'm not promoting it or even using it, purely looking into ideas to help me decide when reducing equity exposure is considered wise!

I appreciate the scepticism and obviously I can't provide clarity on many of the points raised.  

nirish

masonic said:

JohnWinder said:

How much, %/year, should we expect our portfolios to outperform a ‘buy and hold’ approach, and what might be the variation in that outperformance if we use his formula? There might be costs associated with his approach: trading costs, buy/sell spreads, capital gains tax etc; we’d want it to be worth the costs

We could do a quick back-test...

3rd Jan 2020: VIX @ 14, risk free rate at 2% (10 year Treasury yield). Excess return = 5.9%, stddev^2 = 2.

5.9/2 = 295%, which is the recommended amount to put into equities. Let's round down to 100%

Buy $10,000 S&P500 @ 3235 = 309 units

20th Mar 2020: VIX @ 66, risk free rate at 0.6. Excess return = 7.3%, stddev^2 = 44

7.3/44 = 17%, which is the recommended amount to put into equities.

Sell 256 units @ 2305 = $5900 (-$2381)

Hold 53 units worth $1222

5th Jun 2020: VIX @ 25, risk free rate at 1.5%. Excess return =  6.4%, stddev^2 = 6.25

6.4/6.25 = 102%, which is the recommended amount to put into equities... 100%

Buy $5900 S&P500 @ 3194 = 185 units

Now holding 238 units instead of the original 309

Oh yea of little faith!

Edit: appreciate I used the long term return of VTI in the calcs, but S&P500 for the trades for ease of looking up figures. I probably should have used the long term return of the S&P500 @ 9% (1996-2022), which would have made the numbers slightly more ridiculous.

So what you're saying is based on these three back-test points you found it to fail ???

Shame I can't find more information on the background of the formula etc. and the article writers usage of it.

One point of variance, pardon the pun, is that the VIX seems to vary greatly from month to month based on your calculations.  From what I can the standard deviation of the Vanguard Global All Cap which I primarily use is much more consistent around 12-14% so the current risk free rate would be the biggest contributor to the calculation outcome.