Asset Allocation Folklore Revisited

When people thought the sun revolved around the world (geocentrism), the quality of navigational advice was sketchy at best, and might have been downright dangerous at times. For the past twenty years, the quality of investing advice has been tainted by the idea that the one-time selection of investors’ stock/bond portfolio mix accounts for 93.6 percent of the ultimate portfolio return. The idea that investors should try to “time the market” is considered heresy. This flawed perspective has been perpetuated by the marketing department of financial behemoths, widely read financial periodicals, and (more than likely) your broker, regardless of his or her employer. Unfortunately, this common asset allocation myth is causing investors to make bad decisions regarding their financial future and threatening the financial house of investors across the globe.

            Wall Street has taught most financial advisors that it is a waste of time to manage their degree of exposure to risky assets. Finally, however, in his February 2010 Financial Analysts Journal article, asset allocation guru Roger Ibbotson observes that “the idea that “asset allocation policy” explains more than 90 percent of performance has become accepted folklore… The time has come for folklore to be replaced with reality. Asset allocation is very important, but nowhere near 90 percent” as claimed by traditional industry thinking.

            Indeed, asset allocation is extremely important – but the famous Brinson, Hood and Beehower article, Determinants of Portfolio Performance published in 1986, never concluded that a static policy is therefore best.

   

Doug May

         But as a result of the traditional interpretation of that 1986 study, nearly all financial advisors place clients in a static (never changing) mix of stocks, bonds and/or cash. Have you noticed that in every market environment, and in all economic conditions, your allocations to the magical mix stay constant? As a result, clients pay advisors significant fees but get no real advice in return about when to increase or decrease exposure to stocks, the asset class most likely to cause investors to lose money. In addition, clients underutilize stocks because many are unwilling to accept so much portfolio volatility through good times and bad.

            Upside volatility is great, but downside volatility is what investors remember. In fact, the entire industry gets accused of doing nothing for their money, when part of what financial advisors deliver is general financial planning advice, but advisors price it in the value-added clothing of a true investment manager. Consequently, consumers neither seek nor get either financial planning advice (which they probably need) or investment allocation advice (which they want, but can’t find an advisor willing to provide this guidance).

            Many advisors have replaced actively managed portfolios with an indexing approach, but indexing leaves clients vulnerable to market volatility because they are forced to “buy and hold” through all types of markets. Investors who cut back on equities may have to reduce return expectations and, therefore, their standard of living in retirement, and reducing equity exposure leaves investors more vulnerable to inflation at a time when inflation is creeping higher and shadow inflation statistics suggest that the real level of inflation is much worse than is officially reported.

            May-Investments’ solution is to allow “Beta” (the fancy statistical name for portfolio volatility) to vary so that in high-risk markets, clients aren’t completely exposed to a huge market decline. If “asset allocation policy” is the most important determinant of portfolio return (and it is), then a flexible Beta approach allows a portfolio’s allocation to stocks, bonds or cash to vary according to the current economic environment and market opportunity set investors face.

            A flexible approach allows risk to be reduced during the most dangerous times. In addition, cash can be set aside so that it is available to repurchase stocks when either risk is reduced, or stock prices become more attractive. By timing markets (imperfectly, but as well as we can), we can transform volatility from merely being a statistical proxy for market risk into the generator of opportunity for future returns. Buy low, sell high. Isn’t that the idea?

            Galileo was considered a heretic for supporting heliocentrism, and most traditionalists in the financial services industry view our approach with equal disdain. Galileo spent the last nine years of his life living under house arrest, condemned by Pope Urban VIII’s inquisition of being “vehemently suspect of heresy.” There is no substantiation to the rumor that he recanted at his trial by muttering the rebellious phrase, ‘I could agree with you — but then we would both be wrong.’

About
Doug May, a Chartered Financial Analyst, serves as director of the Mountain West Region for WealthSource Partners, an investment adviser registered with the U.S. Securities & Exchange Commission. Registration with the SEC doesn’t imply a certain level of skill or training. The opinions and views expressed are those of Doug May and don’t necessarily reflect the opinions and views of WealthSource Partners. All investing involves risk of loss. WealthSource Partners operates an office in Grand Junction at 744 Horizon Court, Suite 350. For more information, call 263-5126 or visit www.wealthsource.com.
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Posted by on Nov 22 2011. Filed under Contributors. You can follow any responses to this entry through the RSS 2.0. Both comments and pings are currently closed.

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