I’m confused by the risk tolerance of typical investor involved in the 3 rebalacing strats. Can someone please correct me?
Buy and Hold: risk tolerance is positively related to wealth and stock market return. This makes sense because as stock increases, you don’t change your holding so your risk tolerance must also be increased.
Constant mix: risk tolerance that varies proportionally with wealth. This is where I’m confused. When stock goes up, portfolio under constant mix will sell. Doesn’t that mean that as your wealth increases, your risk tolerance decreases?
CPPI: risk tolerance increases as wealth increases. Again, my understanding is that this is basically buy and hold with floor established dynamically. When your stock goes up, you buy more so your risk tolerance must have increased.
I’m not too confident that I’m understanding any of those 3 reasonings. Would appreciate any help.
I might be wrong but this section of the text doesn’t talk about utility from wealth, more so the return-benefit from picking a type of strategy and what the long-term investment outcome is.
Buy and Hold: Doesn’t out perform, doesn’t under perform. Performance is linear
Constant Mix: Underperforms in bull markets, out performs in bear markets - sells winners, buys losers. Concave payout
CPPI: Over performs in bull markets, underperforms in bear markets. Convex payout
Buy and Hold (BH): Linear. As market increases in value, wealth, investment in the market and risk tolerance increases. As market decreases in value, wealth, investment in the market and risk tolerance decreases. Basically, don’t do anything.
Just buy and hold.
Upside is infinite.
Tax and transaction cost advantages
Constant Mix (CM): As the market increases or decreases in value, the % allocation to the market also increases but you but you buy/sell more to remain at the original asset allocation %.
Just hold a constant mix % in the market as per your original asset allocation
Reduced upside
Less tax and transaction cost efficient
Contrarian strategy
BEST IN MEAN-REVERTING (VOLATILE) MARKETS. SELL HIGH AND BUY LOW.
Constant Proportion (CPPI): As the market increases or decreases in value, the % allocation to the market increases/decreases but you buy and sell more to increase/decrease your allocation from the original allocation
Accelerating upside
Momentum Strategy
Less tax and transaction cost efficient
BEST IN TRENDING MARKETS: BUY WINNERS, SELL LOSERS