Wednesday, 21 April 2021

Stock market and gold bubbles - is comparing stock indices to the gold price a useful dynamic asset allocation tool?

Aside from determining your risk tolerance, investment time frame, and hence a suitable asset allocation to invest in (preferably via low cost options such as ETFs and index funds), one of the few well proven methods to reduce risk (volatility) and improve performance (slightly) in your investment portfolio is to rebalance to your chosen asset allocation on a regular basis. Due to transaction costs (and CGT implications) this is often done annually.

Rebalancing will automatically sell off those assets (or asset class) that have done well, and buy more of those assets (or asset class) that have underperformed. While this is counter-intuitive (human nature, such as recency bias, prompts us to want to stick with 'winners' and sell 'losers'), it is usually a good strategy due to the 'bubbles' that regularly occur in various assets, and the tendency for those assets to subsequently suffer 'reversion to the mean'.

An extension of this might be to actually go 'underweight' assets (or asset classes) that have recently outperformed and go 'overweight' those assets (or asset classes) that have underperformed when you do your annual rebalancing. This isn't guaranteed to work, as your rebalancing period (one year) may not coincide with the duration of the various 'boom and bust' cycles experienced by various assets. That is, you may sell off outperforming assets and switch into underperforming assets too early in the cycle.

Therefore, it may be better to slowly adjust your asset allocations above or below your target (standard) allocation over several rebalancing periods - every year that an asset class is underperforming you would slightly increase its weighting, and every year that an asset class is outperforming you would slightly decrease its weighting. I don't personally do any rebalancing, as I mostly invest in diversified multi-index funds that are automatically rebalanced.

However, it might be interesting to see how such a strategy might perform over time. As an example, I came across a chart of the US Dow Jones index expressed as a multiple of ounces of gold. As gold is (theoretically) a hedge against inflation in the long term, such a chart should essentially show the real (inflation adjusted) returns of the stock market. The chart will also highlight when stocks are overpriced (a 'bubble') or when gold is overpriced. Hence if one had a portfolio consisting of the Dow Jones Index and an investment in gold bullion, it would be possible to reduce one's target asset allocation for stocks down when the stock index 'gold price' is well above the 'normal' range, and reduce one's target asset allocation to gold when the stock market is 'cheap' in terms of gold. It can be seen from this chart that seems quite clear when the stock market (DJI) was 'expensive' in terms of ounces of gold, and when it was 'cheap' (and hence either gold was in a bubble or the stock market was excellent value).

I'll look up some historic data for the Australia All Ords Index and the gold spot price in AUD and do a similar plot, then try out some weighting adjustment methods back-tested on the historic data. Hopefully adjusting the target asset allocation this way might boost returns and reduce volatility compared to using a fixed asset allocation (eg. 80% stock index and 20% gold) over the long term. From the above chart it looks like the typical cycles extend over decades, so this probably isn't something I can benefit from, but it might be useful to a young investor such as DS1. I'll see how the modelling results turn out. 

Incidentally, despite there being a lot of youtube videos about gold (and silver) being a great investment at the moment (due to the prospects for higher inflation resulting from the recent massive amounts of stimulus and effectively 'printing money'), and other videos (such as those by Harry Dent) stating that the stock market (especially the US) being in a 'bubble' and about to crash (40% by April, Dent was claiming back in Feb), the above chart doesn't show the Dow Jones Index being exceptionally expensive compared to gold,

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