With all of the market turmoil we have experienced over the past two years or so, most portfolios, if they have not been rebalanced recently, are out of balance with the investment objectives and risk tolerance of the investor and need to be rebalanced immediately. Because asset allocation—the division of assets among the various types of investments such as stocks, bonds, cash, commodities, and real estate—is the single most important aspect of investment performance, it is absolutely imperative that portfolios are rebalanced anytime the allocation moves away from the correct allocation. In this week’s column, I will discuss the ins and outs of asset allocation, point out some of the pitfalls of how the asset allocation process is undertaken by many advisors, and offer some pointers to help investors make the right decisions regarding their asset allocations.
As I stated, asset allocation is simply the way one divides up their assets among all of the various asset types or classes. Within stocks, we have a long list of subcategories, such as large capitalization growth, small-cap value, emerging markets, S&P 500 (or any other) indexed, etc., etc. Within bonds or fixed income, we have taxable and tax-frees, and then we have all manner of credit qualities and maturities, as well as corporate versus governments, international, and so on. Needless to say, there are hundreds of choices here, so the process of asset allocation can get very complicated, very quickly.
Normally, one would want to find an expert on asset allocation, to help them determine which of these many asset classes should belong in their specific portfolio. The problem lies in finding an expert (more on this later). For now, let me explain why asset allocation is so important to portfolio performance. Many studies have been performed over the years to determine what makes portfolio performance tick, and what has come from these studies is that asset allocation accounts for up to 90% of total portfolio performance—yes, 90%! To put it another way; performance was not driven by individual investment selection, such as picking the right stock or bond for the portfolio. This seems strange, since most advisors appear to spend most of their time trying to pick the perfect individual investments for portfolios. In fact, most mutual fund managers and analysts gain and keep their reputations precisely by picking individual securities that perform well. Why is this seen by the investing public and presented by the media as being so important when statistical research proves it is almost immaterial? Answer: money. There is a lot of money to be made in the investment management business and one way to draw investors in is by claiming to be a guru stock or bond picker.
Let’s look at the history of asset allocation for a moment, to see how it developed and how it is used within the financial services/investment management industry. First, most, if not all, asset allocation software programs are based in part or in whole on the Markowitz Efficient Frontier. Markowitz, looking for a topic for his PhD thesis, stumbled upon an old study (this was back in the 1950’s I believe) that showed various risk and return calculation for different types of investments. He has an epiphany, as it occurred to him that there should be a way to combine these various investment vehicles into different proportions until the combination with the best expected performance could be identified—the most efficient portfolio. He did the calculations, and identified the combination of investments in the right proportions that would have the highest return at each level of risk. By graphing each of these portfolios with risk on one axis and return on the other, he was able to create what is known today as the efficient frontier.
This was as far as Markowitz took the idea. He got his PhD, and his work was largely forgotten for a long time. That is, until some finance guy got a hold of it. Keep in mind that Markowitz is an economist, not a finance or investments guy. He never intended for his Efficient Frontier to become the backbone of an entire industry and investment philosophy (although he did win the Nobel Prize for his work).
Fast forward to today, and we see that the entire financial services/investment management industry is driven by asset allocation. The world would be a wonderfully simple and easy place to live if only life fit neatly into shiny little boxes. Unfortunately, life does not and neither does investing.
Some of the many problems with the current asset allocation process, as used by virtually every investment adviser out there are:
- Almost every program uses historical averages (say over 25 years) for risk and returns for each asset class
- They also usually use a long-term historical average for inflation and other economic variables
- They do not take into account (at all) the possibility of catastrophic shocks to the markets (like we just had in 2008)
- Because they are based on historical data, they incorporate no information about the current economic situation, much less what is expected to occur in the future
- In almost every case, these programs are operated by inexperienced “advisors” who don’t have the first clue how the programs work, or what their weaknesses are (the programs or the advisors)
- The programs make their recommendations not only on the historical data mentioned above, but also on correlation calculations—the relative performance of the various pairs of asset classes—based on historical averages as well
- There are a host of simplifying assumptions used to make these programs function (otherwise they would not work at all), including one that always bothers me, which is that investors are rational—give me a break! If they were rational, we would never have bubbles and implosions, which we are all too familiar with in the real estate and stock markets of late.
I could keep going, but I am running out of space. The point is that these programs are dubious at best, and are operated by individuals that are, let’s say, less than qualified.
To elaborate a bit on some of the points above, one of the key assumptions in these programs is that international assets are not highly correlated—don’t move in the same direction at the same time—as U.S.-based investments. As an example, they assume that large-cap growth stocks in Europe do not trade in the same direction at the same time as U.S. large-cap stocks. They justify this assumption by doing correlation calculations that show a statistically low correlation over a long period of time. The implication is that you should own foreign investments because, if we have trouble in the U.S. markets, the foreign investments will not go down, or at least will not go down as much. Excuse me? What just happened when the U.S. market got crushed after Lehman Brothers failed in September of 2008? When our market got hit, the whole world got hit worse!
Correlations do not remain static. In fact, when things get ugly, which is when you need these assets to not be highly correlated, they all line up and go in the same direction! This is the exact reason you should not want to own these investments! The scary thing is that, even though this just happened, and the result was devastating to investors with supposedly well diversified portfolios holding foreign investments, no one woke up and said, hey, wait a minute, we just had the ultimate test of asset allocation programs and they failed miserably! We need to change the way we do things immediately. In fact, just the opposite is happening—“advisors are going right on using these same programs making the same recommendations. (I keep placing advisor in quotes because their advice isn’t usually worth much.)
One other quick note… I see asset allocations that have been presented to clients all the time that include real estate recommendations. The programs include real estate because again, it is assumed to not be highly correlated with other asset classes. Do I even have to point out that this is completely false? Worse yet, and especially for local investors, most own their homes or at least have significant equity in them. This is a real estate investment! Most investors in Santa Barbara are actually over-weighted in real estate—it is a huge percentage of their total assets, so the last thing they should be doing is buying even more!
With all of this said, what is an investor supposed to do? Well, for one thing, if an advisor presents an asset allocation to you with international and real estate recommendations, run. Also, ask them what their capital market assumptions are—the assumptions for risk and return and for economic variables like inflation. If they can’t answer satisfactorily, they don’t have a clue and therefore their recommendations are meaningless (and probably dangerous). Lastly, your asset allocation should take into account not only what investments have done in the past, but more importantly what they are expected to do in the future and what the overall economic environment is expected to be. Think about it this way—a turkey sees life as an easy going, comfortable existence. He hangs out with his friends. the farmer rings him food each day at the same time. He has a nice warm shelter to sleep in. Life is grand and carefree; right up until Thanksgiving Day when he gets his head chopped off. Don’t be the turkey!