Follow Your Risk Tolerance – How to allocate capital like investment professionals |

If you have an 80-90% allocation to equities (as a % of your total net worth), in general, in today’s market you may need to re-evaluate your position. The best way to visualise why is to take a good long look at the chart above for the American S&P 500. Fundamentally US equity prices have gone through the roof: putting aside fundamental measures, the index has had a peak-to-trough return of 4.4x as it rode from a low of 689 to today’s high of 3039 and it stands as the longest rally in history.

Allocating 80-90% of your net worth to stocks today means that you truly accept the risk that stocks – and your precious portfolio – could fall 35-40% next year.

For those of you who aren’t 100% certain that they accept that risk, I’d like to break down what other investing legends are doing, and to provide an easy rubric for deciding how much risk you should be taking.

Why? There are hundreds of reasons why being conservative in 2019 is critical during the late stages of a Bull market. Here are the Top Ten:

1. Despite claims otherwise, Warren Buffett is being cautious.

Warren Buffett has $128bn in cash, which is 55.4% of his entire stake in stocks and common shares.

Don’t get me wrong – I idolise and respect Warren Buffett. He’s the investing legend and I have read his papers and most of Berkshire Hathaway’s annual letters.

Let’s take a look at Berkshire Hathaway’s cash position, as he seeks to sock away a war chest of cash for the next major downturn so that he can snap up undervalued businesses:

Buffett dances around one thing rather cunningly: he believes that this market is highly over-valued. In order to prepare for the future, he is not a net buyer of stocks and businesses. So in effect he is timing the market (or in his words, waiting for a moment to strike, when asset prices are weak). Why else would his cash position be higher than at any time in Berkshire Hathaway’s long history?

Warren Buffett

Berkshire Hathaway

Market Cap: $528.38bn

Equity Portfolio: $231bn

Cash Pile: $128bn

Cash % Stocks: 55.4%

In fact when you look at cash (grey lines) as a proportion of Berkshire Hathaway’s total investing assets, going back to 1995, you find that it peaks right before the next recession. At present BRK holds 55% in cash compared to the total equity portfolio. That figure was less than half after the GFC, when Berkshire went on a buying spree.

2. IPO Mania and Mispriced Fundamentals

Without wishing to labour the point the issues with We Work, Uber, Just Eat, Beyond Meat, Tesla and other cash-burning machines are endless. The fundamentals behind these businesses are staggeringly bad, and suggest a stock market that will put money into anything with reckless abandon. It will all – eventually – tip over.

We Work has received between $4-5 billion dollars as a cash injection from SoftBank, valuing the business at just under $8 billion on paper. You might wonder why it was mooted to be worth $47 billion earlier this year when it planned to IPO on the stock market? The answer is – it wasn’t – and arguably it isn’t worth $8 billion either.

The laws of physics that govern financial markets cannot be defied forever, so it was (and is) only a matter of time before these businesses that are surviving off of investor money and not producing real returns of their own finally run out of cash.

3. Investing legends suggest caution – including Robert Shiller, Jeremy Siegel, Ray Dalio, Jeff Gundlach, and others. Follow their moves!

Robert Shiller’s latest book on Narrative Economics spells out the view that – in fact – stock markets are a lot more strongly correlated with ‘narratives’ and human beliefs about things then we care to think. In other words: throw out the idea of an efficient market, in many ways, because the stories and narratives that we share in the media and society in general have a meaningful impact on asset prices. Right now that narrative is embodied by Donald Trump and it’s about conspicuous consumption and being rich. Shiller cautions that eventually narratives change and the next one might be a fear of recession that takes hold over the market.

Jeff Gundlach (who manages $147bn at DoubleLine Capital) made a famous and significant bet on Gold this year that is up 20%. Although I think there is still room for the market to run, he’s done an excellent job getting a return from gold and bonds in a difficult market. Gundlach places the odds of a recession happening in the next 18 months at over 50%.

Jeff Gundlach

DoubleLine Capital

Assets Under Management: $147bn

Equity Allocation: $7.8bn to $13.5bn

Cash Pile: Minimal

Non-Equity Allocation: 91%

I mention this because I believe following key investing legends is an excellent way to learn. Unless you have stronger conviction for an empirical reason about where asset prices are headed, then perhaps it is useful to follow some of their moves.

4. On most traditional measures stocks are valued well above average and you are therefore paying above-odds for them in today’s market

This is such a massive topic, with a huge body of evidence behind it that I am going to have to leave justifying it to a separate blog post. The only caveat I have, though, is a big one: if you’re starting out with investing and you don’t have any exposure to stocks and shares at the moment, then perhaps you can afford to take more risk as a result of your longer time horizon.

5. American and British Elections – uncertainty is really out there

Goldman Sachs has recently come out to warn that the Democrats’ plan to raise taxes in the United States could very well lead to a stock market crash. This is a bit like Schrödinger’s Cat: it is both true and un-true. I believe that the narrative that Democrats winning the White House will destroy the good business ethos that has been built up in Wall Street, is generally speaking, true. And that powerful narrative will drive asset prices lower.

However, in reality, the Democrats will not completely annihilate corporate America. Look at Obama: in many ways the majority of the stock market rally that Trump claims credit for actually happened under the Obama administration.

So an American election could go either way and be detrimental to stock prices.

The British election is looking even more uncertain. Boris Johnson has come and to say that he will not combine forces with Nigel Farage and he must believe he has good chances of getting voted in. The odds do appear to be slightly tipped in his favour: votes for Labour would all but abolish people’s ability to enact Brexit in the first place and we know that a slightly larger amount of people in the country support Brexit.

Boris Johnson is, however, deeply unpopular. As a result a surprise Labour win would be quite a shock to the system given that he’s floated ideas like re-Nationalising businesses and forcing through new taxation on the wealthy including raising taxes and wealth transfer tax.

Follow Good Advice – Don’t be a Cowboy

Let’s not prolong this: you probably want to know what you can do about this and what it means for potential asset allocation decisions. You cannot generally time the market, but there is sense in not putting all of your eggs in one basket, and accepting a high degree of risk for a more limited reward.

Well, therein lies the challenge and what we say here certainly doesn’t constitute investing advice.

However you should take a serious look at your asset allocation and ensure that you have not taken on more risk than you are comfortable with. Here is an extremely useful table from Berstein’s The Intelligent Asset Allocator, for determining your asset allocation based on how much risk you are willing to take:

This should be considered in relation to your net assets. For a useful guide on tracking your net assets and net worth, please go to the Tracking Finances section and download our free Frugal Investors excel sheet.

From my vantage point I am comfortable with a 20% peak-to-trough fall in my portfolio during a downturn. That means that I should have 50% of my total portfolio invested in stocks and shares. That implies that IF equity markets fall 40% then I will experience a 20% fall (which is half of that dramatic fall). That’s a very decent proposition and one that is easy to follow over many decades. Allocate half of your investments to stocks and shares, and the other half to bonds, fixed income, real estate and alternative assets.

Remember especially when you’re younger, oftentimes the very best of things is in front of you. That means – for me at 33 years old – I could very well dramatically increase my equity and asset allocation in my 40s or 50s when equities become more fairly value. Especially if I believed that there was actually an extremely LOW possibility of equities falling 40% (like Buffett expressed in 2009, when he said stocks would likely return more than 10% per year).

Managing your risk profile and understanding how much of your net worth to put on the table is an important decision. Here are two questions to leave you with: