While valuation can help to identify opportunities and risks by revealing if an investment is over- or under-priced, it cannot identify when that discrepancy between valuation and price will change. Also, valuation can’t identify what the catalyst that causes the change in price might be. Here other factors such as sentiment are also important. Nobody said It was easy Forming a view on market sentiment can be difficult. To illustrate, John Maynard Keynes used the analogy of a newspaper competition in which hundreds of competitors have to pick the six prettiest faces from hundreds of photographs: “So that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view… We have reached the third degree where we devote our intelligences to anticipating what average opinion expects average opinion to be.”

So while valuation is important, an expected ‘average opinion’ can exert a powerful influence on asset prices. It can be some time before prices reflect value. Does this mean that investors should wait for a clear catalyst before changing their asset allocation? The danger with waiting for certainty is that if you can identify reasons why prices will change, then chances are many other investors have also noticed this information and it has already begun to be reflected in the price. Given this uncertainty, how can investors position their portfolios to avoid the risk of over-paying or to take advantage of cheap prices? Give yourself time. The more tactical or short term your asset allocation view, the more difficult it will be to get it right. Most of the academic work suggests that momentum works in the short term and value works in the medium to long-term. Give yourself room to move. It is prudent to average into and out of positions. Also, avoid moving directly from an underweight to an overweight position and bypassing a neutral position.Of course there is much more to asset allocation than just valuation and sentiment. In a future article other important considerations will be discussed.