Tuesday, March 29, 2005

Perpetual Allocation to Equity

I invest for the long-run based on two underlying assumptions about equity price behavior:

a) Secular Rise: That the overall long-run secular rise of equity values will continue (due to the nature of capitalism, as I have outlined in my 21-Jan-2005 post on “Capitalism and Long-Term Investing”); and

b) Short-Run Indifference: That my chance of success in "timing" the overall market (i.e., knowing when the market will rise or fall in the short run) is little better than the 50/50 odds I get from tossing a coin. (However, if I ever find a short-term timing system that I consider reliable enough to trade on, I will of course use it!)

These assumptions lead me to run a perpetually fully invested portfolio, selling one asset and buying another asset only when I believe that an asset I do not currently own offers better “relative value” (i.e., a higher upside-downside ratio) than something I already own.

Generally, there are two types of equity that I invest in: stocks and real estate. When I sell a stock, I typically also buy another stock that very same day using the sale proceeds. This way, I remain fully invested in the market.

I have tried to apply the same principle when I sell real estate, buying a new “upleg” property at the same time I am selling the “downleg,” to take advantage of tax-deferred 1031 exchange opportunities as well. However, due to a scarcity of appropriate upleg properties, I have in the past opted to trade into stocks rather than immediately go back into real estate. (I would rather pay capital gains tax on my sale of real estate than buy an upleg property I really do not want to own.)

My behavior when I am moving capital across asset classes reveals just how strong my preference is to stay fully invested--always--in some type of equity: If I sell a property to buy a stock, I will buy the stock as soon as the escrow company working on the real estate transaction wires the equity from sale of the property into my securities account. In the other direction, if I am selling stock to buy property, I will typically wait until the very last week prior to close of escrow before selling the stock to generate the proceeds needed to close escrow on the property.

With there being thousands of different publicly listed stocks that I can easily obtain information about and buy (or sell) any day I like, I typically find it much easier to select attractive stocks than to identify promising real estate that I really want to own. For this reason, I tend to use the stock market to “park” funds that I might someday wish to deploy back into real estate if or when a good opportunity arises.


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