Dynamic Asset Allocation - A Behavioral Approach
So you picked your ideal portfolio. Good stocks, some bonds, maybe real estate. Everything is balanced perfectly. Now what? Do you just sit there and never touch it again?
Chapter 8 of “Behavioral Finance for Private Banking” deals with exactly this question. How should your portfolio change over time? Should you rebalance when markets move? Should younger people hold more stocks? And why does the textbook answer keep clashing with what real people actually do?
The Big Theoretical Answer: Nothing Should Change
Two Nobel Prize winners, Paul Samuelson and Robert Merton, proved something called the “no time diversification theorem” back in 1969. In simple terms: if markets are efficient (meaning you can’t predict them), your ideal mix of stocks and bonds should stay the same no matter how long you plan to invest.
Thirty years old? Same allocation. Sixty years old? Same allocation. Market crashed? Rebalance back to the original mix. Market boomed? Rebalance again.
The idea is clean and elegant. If you chose 60% stocks and 40% bonds, you keep it that way. When stocks go up and become 70% of your portfolio, you sell some stocks and buy bonds. When stocks crash and become 50%, you buy more stocks. Always back to 60/40.
Here’s the thing. Almost nobody does this. And there are actually good reasons why.
Time Diversification: Why Young People Hold More Stocks
In practice, most advisors tell young investors to hold more risky assets. The logic? If you have 30 years until retirement, good years will offset bad years. The longer you wait, the more likely stocks beat bonds.
The data supports this. Looking at long-term US stock and bond market data, on a one-year horizon, bonds beat stocks about one out of three years. On a ten-year horizon? Bonds beat stocks only about one out of seven decades. So the longer you can wait, the less scary stocks become.
There is even a simple rule called the “age rule.” Take your retirement age, subtract your current age, and that’s the percentage you put in stocks. If you’re 30 and plan to retire at 65, you hold 35% in stocks. Some fund providers like Fidelity have built entire retirement products around this idea.
But here’s the problem. Traditional finance theory says this shouldn’t matter. If markets are random, time doesn’t help.
Behavioral Finance Explains the Age Rule
So who is right? The theory or the practice?
Behavioral finance gives us the answer. Remember loss aversion? People feel losses about 2.25 times more painfully than gains. A loss-averse investor looking at a one-year window sees a coin flip that might gain 20% or lose 10%. The pain from losing 10% (multiplied by 2.25) outweighs the joy of gaining 20%. So the investor says no.
But stretch that window to two years. Now there’s a 75% chance of making money overall. The math changes. Suddenly the investment looks attractive even for a loss-averse person.
This was first observed by Benartzi and Thaler in 1995. The longer your investment horizon, the more willing you are to take risk. Not because the math of returns changed. Because the way you feel about the possible outcomes changed.
Traditional finance has a different explanation for the age rule, by the way. It says young people have more “human capital,” meaning future earning power. If your investments go badly, you can still work and recover. But as the book notes, this reasoning is kind of cynical. It basically says: if the advisor does a terrible job and loses your money, at least a young client can work longer to make up for it. Not exactly comforting.
When to Rebalance (The Case For)
The basic case for rebalancing is straightforward. If your preferences haven’t changed and your view of the market hasn’t changed, your portfolio should look the same as before. Markets moved? Move them back. You chose that allocation for a reason.
Without rebalancing, your portfolio drifts. After a stock market boom, you’re suddenly holding way more stocks than you planned. After a crash, you’re underweight. Either way, you’ve moved away from what was optimal for you.
The authors show this with a nice visual. Point A is your optimal allocation on the behavioral efficient frontier. When markets go up, you drift to point B. When markets go down, you drift to point C. Neither B nor C is where you should be. Only A is right.
When Not to Rebalance (Three Good Reasons)
But here’s where it gets interesting. The book gives three solid reasons to break the rebalancing rule.
Reason 1: You Have a Specific Goal
The book uses a great example. Berta has 1 million Swiss francs and wants to buy a cottage in the Alps for 1.2 million in two years. She invests in risky assets because the risk-free rate is too low to reach her goal.
After year one, if the market goes up, Berta is close to her target. The smart move? Take profits. Lock in the gains. Switch to safe assets. Don’t rebalance back to risky.
After year one, if the market goes down, Berta is behind. Now she has to stay invested in risky assets. It’s her only shot at reaching 1.2 million. She has nothing to lose by staying aggressive.
This is the opposite of rebalancing. After good times, reduce risk. After bad times, increase risk. It makes perfect sense when you have a fixed target.
Reason 2: You Lost Your Risk Ability
Suppose Berta can afford to lose at most 10% of her wealth. If the market drops and she’s close to that floor, she needs to reduce risk, not add more. This creates pro-cyclical behavior. After gains, you can afford to take more risk. After losses, you must reduce it.
The numbers from the book tell the story. If Berta’s floor is 90% of her wealth, she should start with 38% in risky assets, increase to 54% after good times, and decrease to only 27% after bad times. That’s the opposite of what rebalancing would tell her to do.
Reason 3: You Believe in Momentum
If you think markets have trends (what went up keeps going up, at least for a while), then rebalancing works against you. After a good market, a momentum investor would buy more, not sell. After a bad market, they’d sell more, not buy.
Interestingly, a moderate belief in momentum combined with the usual rebalancing instinct basically produces a buy-and-hold strategy. The momentum effect cancels out the rebalancing effect. You just sit and do nothing. Which is what many investors end up doing anyway.
The Practical Takeaway
The chapter ends with a wise conclusion. Rebalancing should be your default. It’s the benchmark. Most investors can’t predict markets. Most investors overestimate their ability to time things. Given all the behavioral biases we carry around, a simple rebalancing strategy is hard to beat.
But. There are real exceptions. If you have a specific financial goal with a deadline, pure rebalancing might not be right. If your ability to handle losses changes with market conditions, you need to adjust. And if you genuinely have good market insight (rare, but it exists), then a more active approach could work.
The key word is “could.” The book suggests that before abandoning rebalancing, you should seriously question whether your reasons are solid or just biases in disguise.
One more thing that stuck with me. The authors mention that obsessing over a fixed goal can be dangerous. Sometimes it’s smarter to lower your expectations than to increase your risk trying to reach them. Berta might be better off looking at a smaller cottage than gambling everything on the expensive one.
That’s practical wisdom. Not just for investing, but for life.
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