“Investments may be soundly made with either of two alternative intentions: (a) to carry them determinedly through the fluctuations that are reasonably to be expected in the future; or (b) to take advantage of such fluctuations by buying when confidence and prices are low and by selling when both are high” - Ben Graham

For the investor who wishes to receive reasonable returns and is willing to see some fluctuation in the value of their funds but does not wish to put out too much effort, a simple portfolio which tracks both the FTSE100 and government or corporate bond indices is perhaps a good place to start.  One question which will then arise is how much to allocate to each asset class when annually rebalancing the portfolio? 

There is no definite answer but the usual suggestion is 40% to bonds or your age as a percentage in bonds.  Another way is compare the current level of the market to its past level in order to determine whether the future may be brighter than normal, or not. Currently the FTSE100 is around the 6,000 mark which is about 14 times its inflation adjusted earnings over the last decade.  This number is sometimes known as the PE10 and the ratio of the current PE10 to its long run average has been shown to be helpful when determining whether an equity index’s price is high or low and therefore whether future returns will be higher or lower than average1.

The current level is lower than the long run average and historically the lower the level the higher the future returns, at least in the long term.  In a passive index tracking stock/bond fund the target allocation for shares should perhaps be higher than normal to take advantage of this situation.

Using a formula to set target allocations based on the ratio between the current PE10 and its long run average is one way to remove emotion, and possibly poor judgement, from this process.  My own asset allocation formula currently gives the following allocations:

Asset Allocation
FTSE100 80%
Bonds 20%

This approach to asset allocation would have held only 20% in shares at the peak of the dot com boom and 90% at the bottom of the bear market in 2009.  In a model portfolio the returns have beaten a typical 60/40 stock/bond strategy2 …

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