For a multi-asset investor, being underweight equities is a notoriously painful position. They are typically the highest-returning asset available, and reducing your exposure can hurt both in the short and long run. Does this mean you should always avoid doing so?

Not necessarily, but your answer to this question probably says a lot about your investment approach.

Let’s create a simple example to test this. Assume you have a two-asset portfolio with a 20-year time horizon, a growth objective and a balanced risk profile. You can choose between US equities or medium-maturity US inflation-linked bonds, with a starting 60%/40% split.

Is there a level of relative valuation where you would consider moving money from equities and into linkers?

(The focus here is on valuation rather than any macro or tactical reasons for shifting allocations).

I would imagine that a common answer to this question would be “no” – if you have a growth objective then underweighting equities almost never makes sense. But is that really true? What if real yields on the bonds reached 5%, and based on even optimistic assumptions US equities looked priced to deliver 2–3% ahead of inflation?

Constraints on Behaviour

I think the answer to this depends heavily on what type of portfolio you are managing, and what the objectives and constraints are. There are several important considerations:

Do you have a benchmark objective or a return objective?

A traditional benchmark-based objective (let’s say 60% equities and 40% bonds in this instance) makes moving underweight at any time incredibly difficult. Owning less of your highest-returning asset, even if it is expensive, is likely to prove detrimental over the long term. We also know that, over the short run, valuation differentials do not matter much at all, and equities can perform well in any given quarter, irrespective of how they are priced.

Alternatively, if you have a return-focused objective (cash+ or inflation+), the decision-making focus can be more on hitting that target, and the discomfort of holding reduced equity exposure is far less acute. It does not matter so much if equities perform very well and you are underweight, provided you are still achieving your primary goal.

In this way, portfolios with very similar implicit objectives (long-term growth) can behave very differently based on how they are assessed.

Are you focused on delivering growth or meeting liabilities?

If your aim is to deliver long-term growth, then being underweight the asset most likely to provide that may not prove to be a wise move. If, however, you are looking to meet a set of liabilities and can do so with less risk and greater certainty, then moving away from equities when opportunities arise may be prudent.

What are your risk constraints?

One slightly odd constraint might arise if a portfolio is designed to deliver a certain “risk outcome”, usually defined in terms of volatility (a useful but deeply flawed measure). Even if you felt returns from a typically lower-risk asset (bonds) were likely to be higher than equities, it might be difficult to move assets without appearing to take less risk than you are mandated to. (Cue the debate about what risk actually is.)

The point here is not that our constraints entirely determine the approach you might take to allocating away from equities – there are plenty of other factors that should influence your decision – but that they can be influential.

Valuation Mistakes

Away from these constraints there are two other issues – often misunderstood – about equity valuations and asset-allocation decisions that are critical.

Being expensive is not a strong enough reason to underweight equities.

It seems obvious that if equities are expensive and are set to produce lower returns, then being underweight makes sense, but this is not necessarily the case. To justify an underweight on valuation grounds, you need to believe that equities are so expensive that their prospective return is lower than that of competing assets.

Imagine you believe that when equities are fairly valued they are priced to deliver a real return of 5% per annum, but extreme valuations mean that they are now priced at 3% real. Even if you are right about the lower return, you will still underperform if that 3% is higher than the return available from other asset classes.

Where benchmark-relative returns matter, equities have to be priced to deliver returns lower than the replacement asset – not merely be “expensive”- for an underweight based on valuation grounds to work from a performance perspective.

Valuations are largely irrelevant over the short-run, and their impact also wanes over the very long-run.

The general view is that valuations are close to meaningless over the short term and meaningful over the long term. This is only partially true. I would frame it like this:

Short term: Low. Overwhelmed by sentiment and noise.

Medium term (5–15 years): High. Strong influence from starting yield and potential reversion.

Long term (15+ years): Moderate. Positive influence from starting yield, but mean reversion becomes is likely to be overwhelmed by years of compounding earnings growth.

Whereas over the medium term there is the potential twin benefit of valuation mean reversion and an improved starting yield, when the horizon gets very long the impact of valuation mean reversion (if it happens) is likely to become insignificant relative to the contribution from earnings growth.

In fact, if you are a very long-term equity investor and have identified a cheaper, higher-return market, then you do not actually want valuation mean reversion to happen – or at least you want it to happen as late in your holding period as possible.

Why?

Because if you are investing for 20 years and your preferred market has a starting earnings yield of 7% compared with 5% for the alternative, you want to keep reinvesting into that higher earnings yield for many years. If it reverts to 5% immediately, you receive a one-time performance benefit, but that is likely to be marginal compared with the benefit of the higher yield persisting.

(This assumes the 7% is a genuine anomaly rather than fair compensation for lower growth or higher risk. A persistent, uncompensated gap of that kind should be the exception rather than the rule.)

This gets to the heart of the argument as to why, if you have a very long-run horizon, diversified equity exposure will generally be fine even if starting valuations are rich.

Of course, there are exceptions. In the Japanese equity bubble of the 1980s and 1990s, valuations became so extreme and earnings so cyclically elevated, that the earnings growth needed to outrun the correction was far too high. It took decades to right itself. This was, however, an exceptional period.

The sweet spot for a valuation impact is the medium-term, 5–15-year horizon, which should influence any decisions around how valuations might affect your equity allocations, and any decision to move underweight.

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The question posed in this piece is a complex and difficult one for multi-asset investors, and one inevitably shaped by the experience of a prolonged and pronounced bull market in equities. How you answer it almost certainly says a great deal about your approach to investing and the environment in which you operate.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).