THE 2003 INVESTOR'S GUIDE TO ASSET ALLOCATION
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ERROLD F. MOODY JR.
Master of Science in Financial Planning
Life and Disability Insurance Analyst
Registered Investment Advisor
(The book contains a section on asset allocation which is more condensed- and more formally written and up to date- than the article below.)
From an advisor- "Wonderful, wonderful, wonderful. One of the best articles I have EVER read! Thank you for providing your compelling and spot-on insights!"
Literally every magazine, fund family, investment internet site has commentary about the value- actually the necessity- of utilizing asset allocation as a fundamental of proper investing and for maintaining an acceptable level of risk. As such, they usually discuss the past studies by the likes of Brinson who indicated that about 93% of a portfolio's gains (actually variability) are attributable to the classes of securities within the portfolio and but an insignificant amount to individual stock selection or market timing. While this study has come under some nasty fighting during the last couple years regarding whether or not the number is 50%, 65% or whatever, I submit that the element of these fundamentals are valid. Determining the various randomly correlated assets is the key to financial success.
Stock picking is NOT the way to financial success.
“93.6% tells us nothing about the wisdom of tactical asset allocation and security selection.”
Meir Statman, Professor of Finance, University of Santa Clara
Additionally, Harry Markowitz (winner of a Nobel prize in economics), in his paper, Portfolio Selection, effectively developed the efficient frontier which represents the trade-off between risk and expected return faced by an investor when forming his portfolio. The mean-variance analysis developed by his work requires not only knowledge of the expected return and standard deviation on each asset, but also the correlation of returns for each - essentially meaning that you do want various assets that do not all move at the same time for the same reason and in the same amount. This is known as Modern Portfolio Theory (MPT)
Asset Allocation Models Using the Markowitz Approach by Paul D. Kaplan, Ibbotson Associates. A summary of Harry Markowitz's theory of portfolio selection and its long-term impact on investment practice.
But as with numbers, statistics and financial calculations, they need to reflect a constantly changing arena of investing- something that is rarely brought to the consumer's attention- and even to advisers. Further, many advisers and allocations are stiffly defined by some regimented formula that many times- in my mind most of the time- eliminates the real life arena of the consumer. That is absolutely shown by the age weighted allocations. (Subtract your age from 80 or 100 and that indicate the amount of equities, or some other sophomoric "rule of thumb". ) (One of the worst was CNBC. Two inputs, 5 seconds and, voila, you have your allocation. They now have 10 questions (absurd) and say the issue is not frivolous) Even when alterations are offered, the commentary tends to be imbued with formulas only the most ardent economist could understand.
Therefore, what I am attempting to do here is to provide some of the fundamentals (with caveats) as well as new information that needs to be addressed in order to make competent selections of funds/asset classes. It will incorporate some numbers and statistics but, hopefully, in a way that will not turn off either the ardent reader nor the less sophisticated who wishes to learn more. And if you are an investor of any type, the information is mandatory.
But don't expect the norm- nor should you. Per David Markham, "much of the trillion dollar investment industry is built on half truths, incorrect interpretation, flawed data, unrealistic expectations and absurd contradictions."
First, let me address- and dismiss- the issue of asset allocation with individual stocks. Literally the entire populace cannot do it effectively nor knowledgeably so I will eliminate this scenario altogether. While that commentary may appear harsh, it delves into my well known and critical statement regarding diversification. If one does not have a clear understanding of this fundamental, then there seems to be little hope of doing proper asset allocation. The question is this- how many stocks do you have to have in a portfolio in order to insulate due to unsystematic risk?
Additionally, what is the necessary correlation?
Even assuming that the proper number is utilized and with random and/or negative correlation (actually few viable investments will have a negative correlation), you need- at least from the past criteria and readings- to have stocks in large cap, mid cap and small cap; companies with diversification in cyclical, value, growth, etc., Bonds (maybe a Treasury instrument, but is it short, medium or long term?), some cash, precious metals (gold?), stocks of a few few foreign countries, real estate and perhaps some additional allocation based on whatever you think necessary. But in order to so, you have to be able to do intense research at least on the level of a CFA (Chartered Financial Analyst) (do you really know how to read a financial statement and offset depreciation as necessary?? Read the article Flabbergasted by Footnotes. It clearly(?) shows why the use of individual stocks is extremely difficult to analyze for the average investor because the nuances of such issues are almost incomprehensible.) And you also need to be fully cognizant of national and international economics (have you read any FED papers in the last couple weeks?). This never happens. Only a very few people possess the skills and the time to put together a properly diversified portfolio of individual securities with an adequate analysis of all the interrelating factors. (I am not one of them either. I may have to analyze specific issues per the request of a client, but attempting to design an entire portfolio of singular issues, I refuse to do.) In any case, if you do not know these interrelating factors, any personal attempt to design a portfolio of randomly correlated securities is almost ludicrous. You might succeed, but it will not be because of knowledge.
Something that psychologists certainly know and economists never look at is that people don't learn from their own past mistakes. Economics assumes we learn, and because we are able to learn, we can correct. Cognitive psychologists have done a number of studies that show that people don't learn from the past. Because we are not able to learn from the past, we may look at a specific past mistakes and decide if we were only more careful, we could have prevented it. But we don't. We will still get into mania almost the same way the next time and the time after.
Lifson and Geist, The Psychology of Investing
Behavioral economists describe this dynamic -- where otherwise smart people make foolish, often conflicting, financial choices -- as a paradox of human nature. Hence, people make knee-jerk decisions about their financial needs without consulting a professional, even though they know better. According to survey consultant and Cornell University psychologist Dr. Tom Gilovich, this disconnect in financial behavior is likely due to one of three factors: -- Despite the sluggish economy, people remain overconfident in their abilities to manage their finances -- they tend to overestimate their own abilities, knowledge and skills.-- People have a hard time translating good intentions into effective actions. -- People have a general skepticism about others who might take an interest in their finances. Recent corporate scandals have fueled this skepticism by making people question whom to trust.
So what about the (supposed) professional- a broker for example. Unfortunately, brokers have never been required to know the requisite knowledge of risk and reward (I have taught literally all the securities licenses in the past). The NASD/SEC have never required the fundamentals of investing to be required knowledge for brokers (alpha, beta, correlation, diversification, standard deviation , BILL SHARPE , Sharpe Ratio, Monte Carlo, R SQUARED, Capital Asset Pricing Model etc.- they are not tested at all) ) so it is highly debatable that they can knowledgeably address the issues of proper allocation either. In fact, in March 1999, "John Ramsay, deputy general counsel for NASD regulation, says the basic information the brokerage (firm) gets on a (customer) form is usually only enough to make suitable recommendations for the simplest of mutual fund investments. For anything more complicated, an investment adviser would be expected to know much more about the customer." I take it further. The broker would need to at least know the fundamentals of investing to offer even a mutual fund. Something more complicated would require a competency with standard deviation and an understanding of suitability incorporating a pyramid of investing. This is not real life. It therefore means that those brokers who suggest that they understand and properly utilize asset allocation may have simply been successful (if that actually be the case) due to statistics and luck. In the alternative, they may suggest a wrap account of individual securities- but selected by a manager of "x" capability as shown by past success. Most of the major brokerage houses use various forms of wrap accounts where an "acknowledged" adviser buys and sells stocks in a portfolio for a flat fee. But my experience tends to show them still bloated with very high fees (up to 3%) and not addressing asset allocation anyway- just focusing on one fund of the adviser. And few beat the indexes they parallel. Further, you still have the fiasco of the simplistic and essentially demeaning 10 to15 question risk profile form (see additional commentary below) that is normally a wasted effort.
* "Human beings cannot pick stocks. Period."
FINANCIAL ADVISORS, STATISTICAL RETURNS, STATIC ALLOCATIONS: How about the issue of "financial advisors" and "planners" who charge for services in managing portfolios. First, many financial planners are rarely more than assets allocators using computer generated models that profile what has happened in the past and use that as the sole evidence for the returns of the future. Even the most highly promoted allocation on the Internet- Financial Engines- uses information gleaned from thousands of various statistical reports (with weighting) and incorporates them into a computer analysis that allows investors to see how good their future economic prospects may be for an allocation program. (Though it does incorporate Monte Carlo simulations. Monte Carlo methods are stochastic techniques- meaning they are based on the use of random numbers and probability statistics to investigate problems and various economic conditions.) Now, I am certainly not going to state that I have the same capability with statistical evidence as does Bill Sharpe, but my point has always been that while statistical evidence is valuable and a must to analyze, it is not a precursor to future events (something Morningstar also has conceded/included in its commentary) nor does it necessarily even take into account recent commentary on, say, the Japanese , Turkey or Argentina economies.
How about the inverted YIELD CURVE which had existed for more than 2000 and which finally turned normal in 2001. In such regards, an inverted curve is a precursor/leading indicator to a downturn in the market. (And didn't that happen, irrespective of 9/11?) Some say that all this is an attempt at market timing- I submit that reading and a proper interpretation of current economics is THE key to investing new monies and no Monte Carlo simulation is adequate. (Note I am not saying my interpretation would be correct. But I have more faith in my interpretation than that of a computer model that does not even use the information. Pundits are well advised to review the calamity of Long Term Capital based on statistical formulas by two Nobel laureates and a staff of 27 PhD's. The supposedly savvy hedge fund took huge leveraged positions in a number of markets it believed to be unrelated, so that it wasn't hedged against their all going bad at once. But a default by Russia on the heels of troubles in Asia led to a global flight from all kinds of risk. Many of LTCM's bets soured at once, it couldn't unwind them fast enough, and it survived only through a Federal Reserve-orchestrated bailout by banks and securities firms.You essentially had a $3.6 billion bailout by the FED to keep the U.S. banking system afloat. Where were the simulations then???). Further, I wonder if such advice would have told investors to move OUT of the market in 1973/74 (and 2000 forward) or that bond values were going down and down in 1994, etc. You absolutely MUST use statistical analysis- but you must also understand its nuances and proper implications in the marketplace.
What lessons does the saga on Long Term Capital provide the average investor? First, superlative mathematical ability confers no special advantage in the capital markets. Relying solely on your quantitative skills to invest successfully is like trying to fly an airplane based only on an exquisite knowledge of aeronautical engineering, ignoring the need of real-world flying experience and lacking a good sense of the fickleness of both aircraft systems and the weather. This is not to deny that a certain amount of quantitative ability is necessary to invest properly. It's far more important, however, to possess an abiding respect for the unpredictability of the markets and a thorough working knowledge of financial history.
William Bernstein
(Here is an example of extreme arrogance with mathematical formulas "guaranteed" to produce positive results. When a recent market neutral fund kept tanking (buying long and selling short), the manager said that the market simply had not moved as it was supposed to- as though the market is preordained to always move in a particular fashion. That's also to say that people ALWAYS react in the same fashion given certain stimulus. WRONG!!! The emotion of humans can easily distort any assumed reaction. The market is no different since most of it is also emotion driven, at least on the short to medium term. Over time, normalcy takes over as the volatile yearly statistics are muted. But on short time periods, mass hysteria- one way or the other- may rule.)
As an aside on Morningstar- yes I do review the information but I am not lulled by "seeing stars" as the be all and end all of my investigation. Not so with many (most?) of investors. An article in Index Funds Online noted- "In principle, information is always beneficial to the markets, but when large numbers of investors are basing decisions on their retirement income exclusively on ratings such as Morningstar "stars", there is something wrong with investor education. Although Morningstar has clearly stated that stars are not clear indicators of future performance, investors continue to latch on to the appealing rankings." An additional note in late 1999 from a major Online trading firm. They had spent a "small fortune" offering Morningstar statistics- as well as substantial other analytical services. However when the firm analyzed customer attitudes, they found that the "investors" were spending less than a minute before purchase. They simply were reviewing the Morningstar stars and effectively nothing else. "There was a staggering correlation between the way investors were using the site and the number of five star funds (the brokerage) was selling." They then dropped Morningstar and "forced" investors to do more homework before a purchase. Nonetheless, I submit that without an understanding of diversification by the numbers, such homework is tainted from the beginning.
* People who think they can do a thorough job of due diligence with a few computer searches and star rankings are naive..........An adviser with an attitude like that becomes part of the problem, not the solution.
Ronald Rutherford, Author of Managing a Portfolio of Mutual Funds.
To continue with statistical numbers- such reporting of numbers may be an almost complete- or at least relative- distortion of what the statistics portray. For example, did the S&P 500 really increase in 1999? No, not really. How's that? Well, obviously the index did increase substantially- but it was not due to the movement of 500 stocks. Even 100. The bulk of the movement was in just a relatively few large core stocks that held up the entire index. What about NASDAQ? Well, the NASDAQ composite DID go up 70%+ in 1999, but 84.8 percent of NASDAQ stocks were down 10 percent or more from their highs of the year. Now, I am NOT stating that investors should have included just these few stocks into a singular portfolio since it would have defeated the essence of diversification (and is nigh on to impossible to figure out exactly which stocks will do well and when). But to be unaware of the fact leads one to conclusions that are unfounded- and to a potential future focus which cannot be counted upon.
What about addressing small cap stocks- an unquestioned element of asset allocation? Literally every investor recognizes the exceptional returns of the past- and that's again one of my key points. The returns are in the past. And had one focused on past returns, the most recent 10 year small cap returns for an investors would have been dismal- at least in comparison to their larger brethren. Further, it may be that the small cap returns as evidenced by statistics NEVER DID HAPPEN- or at least happened in a way that can be depended upon. I noted previous studies that addressed this point succinctly- once small cap stocks lose ground, they may be delisted. Many actually go out of business. But since they are not followed once delisted below $1, the lower number of zero is not included in the sampling of returns. In mid 1999, 10% of the total NASDAQ market traded under $1. "That's more than the annual totals in many years and is on track to eventually eclipse last year's total of 717 deletions and the record of 719 in 1988." And Professor Siegel of Wharton School said that the exceedingly high returns of small caps between 1974 and 1983 (35% annually) were an anomaly. Once those return were excluded, the returns for small caps actually were LOWER than large caps since 1926. Siegel noted that the returns for large cap stocks in the 80's were hurt by oil price increases, inflation and recession. Hence, the overall statistical returns reported for small cap stocks might not only be immeasurably higher than in real life but only happened "just by chance". As fund manager Robert Markham noted, "The conventional wisdom that small company stocks will out perform large company stocks is false."
What about Value stocks? I will again concede the underlying factors for growth. But once again, a static focus on the "value" asset allocation of the past would have voided tremendous gains of the future in the larger cap growth funds. Ibbottson noted in an article that Value investing is absolutely valid, but conceded that it might be 20+ years before the market would turn to once again reflect its prominence. I offer that the time frame might well be sooner- for all I know it may be just around the corner (it was in 2000- then tanked like the rest of the market). But to continue a focus on allocations not in favor is simply a justification for contrarian investing. True, it may also be valid. But I ask you, why not invest everything in gold- certainly (?) it will also come back. (it has been better in 2001 and 2002, but consider the very high risk. As to value risk, here are some comments on VALUE STOCK by, Larry Swedroe, "The value premium has been large and persistent for a very logical reason - value stocks are not only risky, but their risk is highly correlated with economic cycle risk, which tends to manifest itself during recessions that are also deflationary periods. While we do not have a perfect model to explain the risk of value stocks, investors should not make the mistake of believing that just because value stocks have had a lower standard deviation than growth stocks that the value premium is a free lunch."
Additional commentary by Wharton finance professor A. Craig MacKinlay- "..... value stocks generally outperform growth stocks (although growth stocks recently had their day in the sun)." But "many of the value vs. growth arguments were based on data from 1962 to 1990 and that "happened to be a relatively good period for value stocks in my view, so those conclusions – even though a 30-year period seems long – don’t hold up as strongly."
Regardless of such rhetoric, I still may be wrong. After all, the Brinson, Hood, Beebower report- as interpreted by many - focused on a relatively straight "staying the course" since out of favor assets/stocks would certainly reach prominence once more (though the allocations could be rebalanced on, say, an annual basis, they still reflected "old" statistics). But I never interpreted the report that way (as did a few others). It was clear that allocation orientations are best to diversify risk, but a bad allocation was still, nonetheless, a bad allocation and dismal returns might be anticipated/assured. It was obvious(?) that intensive analysis (reading) of economic fundamentals along with an understanding of securities application might well be a far better (albeit harder) method to determine allocation. Were there others with similar views? Most notable was Bill Jahnke- well known in the investment/allocation arena- who, as of several years ago, voiced an opinion that the Asset Allocation scenario as expressed by Brinson, et al, and utilized by the vast majority of financial advisor and planners, was nothing more than a hoax. Suffice to say, after long, articulate battles, the issue is reasonably well decided effectively in the manner I described. The Brinson report did have value- though the allocations might more realistically reflect a 15%, 30%, 70% (or their) 93.6% position of the overall return. Nonetheless, financial planners have almost steadfastly focused on a set allocation of funds defined primarily through the use of computerized offerings by an innumerable number of companies each promising the best allocation. And each effectively suggesting you stay the course since that is what is easiest (American Express in their 1999 commentary on diversification- "Get clear on your personal goals, then buy and hold a diverse portfolio of investments through thick and thin"). I offer this in contrast to staying the course- and I have repeated and taught the issue for years. Statistics show that maintaining a portfolio of securities through the 1973/74 debacle would have eventually returned an adequate return- and over time the stock orientation out classed other allocations of bonds or cash. But they forget one crucial element- the investor holding the portfolio as they watched their net worth decrease over 45%+ in that short two year period. Sure the market came back- but investors did not break even for about 10+ years. The untold emotional turbulence and family and financial strife could, in no way, offset some advisor's statement-"let's stay the course". Literally every one of those investor's would have preferred being OUT of the market and being able to sleep at night. I submit such commentary- "stay the course"- misses the human element and is inherently flawed from the outset. Maybe institutional investors could have been led to maintain a severely declining portfolio- but I think not. I think the advisor would have been fired for being not only negligent but woefully irresponsible.
And more from Jahnke in a 2003 interview- Bill Jahnke on the flaws in asset allocation. He is quoted extensively in my book. After you read that, read my commentary to him below.
I am in agreement with just about everything written, but find this "fault". Where are the independents- actually even the institutional firms- going to get the knowledge and practical application to start to "tailor situations"?
It's not going to be forthcoming from brokers since they have never even been taught the fundamentals of investing. CFP's are little different. They are given slightly more statistical data but absolutely no practical application to its use. Nothing also with ChFC's CPA PFS, FPA and certainly anyone with NAPFA. There are no residency programs for anything in planning. In fact, the CFP Board would never allow it anyway since they would lose too many existing CFP's who are incompetent to begin with. Planners are all looking for something to simplify the way they work- and the "sophisticated" (albeit sophomoric) allocation programs have provided that.
I just don't see a change until and unless the consumer recognizes what has gone on and demand more professionalism. They have recognized some of the issues with the downfall of the DOW recently. But, then, what do they do? Gravitate like little lemmings to the marketing of the firms that now suggest they have the better way of doing allocation- while offering nothing more than buying yet another allocation program based on a different pile of historical numbers.
I just don't see much of a change until the officers and directors of the various organizations step up to make the effort for change. But they won't. Most make lots of money by snowing the public with gross generalities (Evensky, et al) and are hesitant to slaughter the golden pig.
To continue on the subject of buy and hold- Here is one quote on the subject from the WSJ and Barron's 2002, "The buy-and-hold mantra that was drilled into investors' psyches by the bull market of the '80s and '90s no longer leads to nirvana." And "the buy-and-hold philosophy also argues that stocks go up over time. According to data from Chicago-based Ibbotson Associates, from 1926 to 1999, 90% of five-year periods were positive for stocks. But those figures don't reveal long periods of pain in the stock market. After the 1929 crash, the Dow Jones Industrial Average took 25 years to regain its pre-crash levels. The Dow traded above 1000 in 1968, but failed to close above that level again until 1984."
As regards the tech debacle in 2000/2001/2002, would a heavy investor in tech (or just about any equity position for that matter) feel "comfortable" with 40% and 50%+ losses and just stay put? I do know some that are doing just that- but they were never investors to begin with since they were clearly oblivious to the volatility and diversification risk due to a lack of reading. A studious effort would have clearly identified the exposure. (But people are NOT studious. They have been led to believe by the highly marketed and superfluous articles by the likes of Money, Kiplinger's, Smart Money, ad nauseam, that investing, retirement, pension planning, et al, is relatively uncomplicated and does not require advanced skills. Yet hardly a one of these "professional" entities avoided the tech debacle. Or know what truly was involved with LTC. Now I am not saying that certain features and articles do not have value. I am stating, however, that only about 75% of their material may be valid. The trick is to know which 25% is effectively useless and how it might improperly impact basic planning. I have problems, sometimes, even with my background. Therefore, for the most part, the average consumer doesn't have a clue. Hence, unnecessary problems both financially and emotionally.)
Most investors realize that portfolios have risk, but many do not understand the implications of this risk on their investment goals. For investors, however, the greatest risk is not portfolio volatility; rather, it is the risk of failing to achieve their investment goals.
Tobias E. Timm, C. Michael Carty, and Matthew V. Pierce
As to the asset allocation software per se- is it any good? Perhaps Bill Sharpe said it best with this commentary- "I have been studying software provided by major mutual fund and software companies and have found that it reflects remarkably few of the lessons learned after decades of the development of financial theory and its implementation by and for large institutional investors."
If you put tomfoolery into a computer, nothing comes out of it but tomfoolery. But this tomfoolery, having passed through a very expensive machine, is somehow enobled and no-one dares criticize it.
Pierre Gallois
As regards a buy and hold, From James Martin CFA in Bloomberg 2001,- "While I don't dismiss asset allocation, I do dismiss a mindless black box computer model trying to optimize what today's proper portfolio mix should be. Somehow by dumb luck, or perhaps divine blessing, I learned that the financial markets are nothing more than a confluence of human emotions. And no black box model, no matter how many variables are in its multivariate time series, will replicate and anticipate the collective mind of the market.
The problem is many advisers view asset allocation as a crutch- a substitute for hard work. Or perhaps they simply don't have the confidence in their decision making.
Wall street has done a great disservice selling the concept of asset allocation to the public along with the proliferation of thousands of redundant mutual funds. Mean variance optimization is a concept applicable only to institutions with indefinite life spans, not to individual with finite goals.
I argued that modern portfolio theory was equally incorrect because its entire backbone was supported by the specious assumption that historical cross correlations between asset classes would hold and repeat. Even back then, they (professors) knew that correlations and betas were not stable. Hence, trying to build an optimal portfolio using numerous asset class is a lesson in futility. It is a constantly moving target.
So, we design asset allocation strategies based on needs and liquidity constraints, tax efficiency and that ever subjective "emotional risk tolerance". (But) people never get a true understanding of risk until after they have been through it."
Although we have a fairly good understanding of stock market risk, assessing stock market uncertainty is incomparably harder. The observable past only tells us so much, though, because we cannot tell whether the future will follow the patterns of yore. Uncertainty rises from imperfect knowledge about the way the world behaves.
Frank Schmid, FED Reserve of St Louis
These comments are in direct correlation to the comments from Bill Jahnke in Investment Advisor-
"Asset allocators view their primarily job as getting a client into an asset allocation solution and advising the client not to abandon the asset allocation solution in volatile markets. But if the fixed asset allocation solution is not right for the client and is inflexible in the face of changing economic opportunities, what is the service worth?
Asset allocators claim their advice is designed to benefit the client. But it appears that the advice is really designed to benefit the advisor; the investment process is simplified, and the business risk associated with managing the client's asset allocation is minimized. The asset allocator only needs to provide a package of marketing materials, educate the client on the rewards of diversification, administer the risk tolerance questionnaire, set up a "normal" asset allocation policy, collect the quarterly fee, and advise the client to "stay the course" in volatile markets.
Asset allocations claim there is an effort by elements of the financial services industry to undermine their message. They argue that investors are being bombarded to buy into the hottest performing asset classes. Much of the financial planner's efforts are directed at combating a financial service industry that has found it easier to sell past successes and hot new ideas than to sell undervalued investments. It is little wonder that many investors tend to buy high and sell low. The problem is not, though, a sufficient defense for the allocator position that investors should "stay the course" regardless of the state of the economy and asset valuation levels.
The view that there is nothing to be gained by an ongoing evaluation of investment opportunities and the positioning of client portfolios in response to those opportunities is extreme and dangerous. The fact that assessing further prospects is difficult and subject to error is no defense for not doing it. Given that most allocated investment solutions are poor interpretations of investment theory and have little to do with meeting financial objectives, the advice to "stay the course" is especially hollow."
Additionally, from Investment Analysis and Portfolio Management by Cohen, Zinbarg and Zeikel, Irwin, 5th Edition- "A substantial bond of research clearly indicates that most investors, not only individuals but financial institutions, do not manage their portfolios effectively, That is, investors do not construct or manage their portfolios in a manner that reflects their attitude toward risk, nor do they recognize the likely financial consequences of disappointing investment performance." There are "three critical elements that should be central to every rational investor's deliberations: 1. Defining investment objectives clearly and realistically, 2. determining an appropriate asset-mix strategy for achieving these objectives and 3. adopting operating tactics that will effectively implement the broad strategic plan." Further, "capital market conditions are ever-changing and diligent adjustment to important trends is necessary to achieve determined goals consistently over long time periods. Few investors do."
“Asset Allocation Math, Methods and Mistakes” Good article with beta, CAPM, more
I should also address the fact that assume s you got into the market at the wrong time. So what do you do? Simply stay the course? How long would it take to recoup a decent return if you got in right when the market was at its top? Take a look at UP or DOWN and for How Long? "If an investor entered the market during the last century when the Dow was one standard deviation above its long-term trend line - an exuberant bull market top - how long did they have to wait? For an investor who got in at the top in 1929, it took until roughly 1960, in inflation adjusted returns, to merely break even on his investment. At the next big bull top in 1968, it took until the early 1990s to break even - or about 25 years. Also, these are simply break-evens after inflation, a 0% return. These figures do not include dividends (data from Siegel, p. 59). Leuthold (InvestmentNews, 5/21/2001) notes that an investor at the peak in 1929 took until August 1998 - almost 69 years - to reach a nominal return of 10% on his money, including dividends. After inflation, this is a yearly return of about 7%. It took investors 69 years to reach the long-term expected return from stocks.
In addition, from its peak in 1929, our long-term investor had to endure an 86% decline in the value of his portfolio to its low in July 1932. The Dow Industrials holds some of America's largest and financially soundest companies, and cannot be considered an aggressive or speculative part of the stock market. Yet, investors choosing this relatively conservative sector would have required extraordinary nerves, and several decades to achieve average long-term stock returns on their investment, far more than can be realistically expected."
The articles suggesting you stay the course have been written by "journalists" who have never read the true research reports and could not write this article. But a 2001 NBC report indicated that about 50% of U.S. citizens do not feel that reading provides much value.
Here is an additional commentary on risk management from the WSJ 2002: This is the problem with quantitative software including that used by financial planners. "Sophisticated computer models used by big companies are supposed to help them plan for all sorts of financial risks. Until lately, these mostly worked well. But models typically use history as the starting point for their predictions. That can give false comfort, leaving them unprepared and their companies under pressure when the markets tear up the history books.
Since the 2000 bull-market peak, the Nasdaq Composite Index is down 76%, the steepest, quickest slide in any major market index in history. The Dow Jones Industrial Average is off by more than 32% from its high, its worst percentage decline since the 1970s.
Haunting some investors are memories of the 1998 near-collapse of Long-Term Capital Management. The supposedly savvy hedge fund took huge leveraged positions in a number of markets it believed to be unrelated, so that it wasn't hedged against their all going bad at once. But a default by Russia on the heels of troubles in Asia led to a global flight from all kinds of risk. Many of LTCM's bets soured at once, it couldn't unwind them fast enough, and it survived only through a Federal Reserve-orchestrated bailout by banks and securities firms.
As it happens, today's widespread underestimation of risk stems from a big drive in the past decade to get a better handle on risk. In the early 1990s, J.P. Morgan & Co. derived a model called "value at risk" that allowed it to see, on a given day, how much the bank stood to lose if the markets' behavior was consistent with their recent performance. It even gave a specific degree of certainty to executives: 95%. (That means that there is still a risk of the 5%)
The models weren't meant to be used as crystal balls but only as a first step in a company's risk-management process. "You still need people to sit there and come up with scenarios for events that haven't happened, could happen -- and could become a shock event that could completely change the market environment.".
Risk models have been especially poor at predicting events in the credit market. To gauge chances a corporate bond will default, many investors use their own computer models, adapted from models designed by credit-raters such as Moody's Investors Service. The rating-agency models typically have used historical data to get a handle on the future. But history hasn't been much of a guide of late. Some models, for instance, show a historical default rate of about 1.6% for all corporate bonds.
The corporate-bond default rate now has hit twice that. Many defaults have even come at companies that had been rated investment-grade. In the second quarter alone, 60 U.S. and foreign companies defaulted on $52.6 billion of rated debt, easily surpassing the $38 billion in the first quarter, which was itself a record, according to data from Standard & Poor's Ratings Service.
"The [ratings agencies'] models have performed extremely poorly. "They have underestimated both the frequency of default and the severity of defaults."
"We look at the worst probable risk, not the worst possible risk."
The last sentence needs further commentary. It is possible to 'program' eventualities over longer trends or even certain periods if the trend has been staying constant. For example, in the early 90's, we had two of the least volatile years in the stock market's history back to back. We had interest rates going down and down. And after 1994, we had a market that went up and up no matter what. You could also take the market after mid 2000 to this posting in October 2002 as a market that has gone down. In each of these situations, there was a way of designing programs that incorporate a statistical probability for the next day, week, month or even year. And within that context, there is a way of designing for the worst probable risk given the current trend. But a program, while it could be designed for long periods of time (say 20 years and more) would do little to provide comfort to the average consumer being demolished by a market that is undergoing dramatic 'seasonal' or 'decade' instability. And therein lies the problem for the consumer- or for that matter planners, advisers, etc. The worst probable risk is generally outside the scope of the current software. And the worst possible risk (which some might say is a 1929 model- but which I believe is closer to 1973/74 and the most recent market) is so far beyond the software that it doesn't necessarily end up on the radar. Yes, Monte Carlo can show numbers but it reflects past history, not how to examine the current market and make adjustments .
MUTUAL FUND DIVERSIFICATION: Assuming one is qualified, knowledgeable and educated in such fundamentals in proper allocation, and in order to provide adequate diversification within a category, diversified mutual funds are the strongest consideration by far. (Almost all are diversified- but be careful. Some offerings in 1997 and 1998 had been focusing on just a few issues in an effort to "ride a wave" of euphoria/momentum. Once in awhile they work but the risk is extensive. By the same token, in 2000, some of these were already out of business. See Survivorship Bias (Larry Swedroe) Anyway, within that context of mutual funds I wish to go further by stating it is the simplest mutual funds that I tend to focus on. Simple being those without- or with little exposure to- extensive derivatives; options, currency hedges and so on. Index funds.
First, let's at least put options, derivatives and such into current and real life perspective. I remember in the last 80's when every brokerage firm was touting the unbelievable ease and lack of risk associated with CMO's- collateralized mortgage obligations. (They take a mortgage and break it into numerous slots of payments (called tranches) where each one bears a different time frame, yield and risk. Supposedly each risk was clearly identified to its exposure given any economic scenario.) Literally all the big firms were pushing these to the ultimate. But I had learned from previous experience that "new" and untested investments tended to show fault lines in the not too distant future. Sure enough- when the problems of 1987 hit, Merrill Lynch lost millions because the CMO's clearly didn't react as anticipated. There was a much greater risk than identified by computer or any other analysis. Now, flash forward to 1998 and Long Term Capital. Here we have two Nobel laureates with quant formulas (computer strategies) to do hedging, options plays and extensive leverage. Yet the turbulent currency markets in October 1998 caused billions of dollars of loss, liquidity restrictions and an effective bailout by the FED. This is not to say that such efforts are not without merit- you can take literally any investment, commodity, hedge vehicle, etc. and place it in certain economic conditions and they will outproduce God him/herself. But such exuberance is suspect and the consistency potentially nonexistent- at least reflecting a reversion to the mean .
As a commentary on reversion; has the entire market changed so that stocks will maintain much higher P/E ratios of 30? Or must there be an inherent reversion to the mean? I suggest you review, New Paradigm or Mean Reversion by Jeremy Grantham and Jack Gray (PDF format only). It demonstrates the fallacy of believing that a short term trend will last forever.
And this should give pause to anyone that "already knows" what a valied P/E ratio:
"Demography and the Long-Run Predictability of the Stock Market" (NY Times) Three professors, John Geanakoplos of Yale, Michael J. P. Magill of the University of Southern California and Martine Quinzii of the University of California at Davis suggest that while the market may rally periodically, its overall direction will be downward until around 2018.
The professors' approach depends on a simple indicator: the ratio of the number of middle-aged people to the number of young adults in the population. When this ratio rises, the overall market's price-to-earnings ratio will rise, too, the professors predict. When the age ratio declines, as it is likely to do until about 2018, the market's P/E will also decline.
The big difference in the sizes of these generations has already led to wide swings in the stock market, the study found. As the first baby boomers approached middle age in 1985 and began investing heavily, their buying more than offset the selling of the older generation then entering retirement. Stocks entered a multiyear bull market.
That trend is reversing, according to the model, which predicts that the market has entered a long decline caused by baby boomers selling stocks as they approach retirement. The sales will be only partially offset by the purchases of the smaller group entering middle age.
The model predicts that this long-term trend will not turn positive again until after 2018, when retirees' stock sales will be more than offset by the purchases of younger investors. This trend will strengthen as the larger baby boom "echo" generation, born between 1985 and 2005, enters middle age."
So back to my point- what are the funds to look at that limit such volatile (and unnecessary) exposure??- your basic vanilla index fund. These are low cost, and what you see is what you get. Further- and repeated in any objective article- index funds outproduce managed funds at least 80% of the time- more so on a risk adjusted analysis. (Further commentary on index funds below)
Asset Allocation: Management Style and Performance by William F. Sharpe. Reprinted from the Journal of Portfolio Management, Winter 1992, pp. 7-19. The author discusses an asset class factor model and how it can be used to "analyze the performance of a set of open-end mutual funds between 1985 and 1989." The twelve classes of assets used in the model: Bills, Intermediate-term Government Bonds, Long-term Government Bonds, Corporate Bonds, Mortgage-Related Securities, Large-Capitalization Value Stocks, Large-Capitalization Growth Stocks, Medium-Capitalization Stocks, Small-Capitalization Stocks, Non-U.S. Bonds, European Stocks and Japanese Stocks
INVESTOR RISK PROFILE: Next, let's take a look at the risks profiles that also need to be addressed in asset allocation. This is also a caustic area of my commentary since, while every fund company and brokerage firm offers a risk profile of some level, they are effectively sophomoric and so extremely limited in use as to be almost useless. Why? Because the questionnaires almost solely identity what you have done in the past- which may have been just plain wrong- as well as what you would like to do in the future- which may just be plain wrong. It's what you need to do in the future that controls the process. It is not what you have done nor what you would like to do nor the risk you would accept. Should the analysis show you MUST take more risk than you'd like, it is irrelevant what you would like to do since the underlying financial requirements override (unless you change the priorities). As an analogy, it's nothing different than flying. You don't know how to do it, you may find it fearful- and you would answer a questionnaire that way. But you may have no alternative but to do it since it is what gets you from A to B in the most expeditious manner- actually at less risk if you really understood it versus other methods (means reading and research). Further, your choices may be limited, if any others are available at all, once you did adequate research.
Below are a few of the major risk sites that you can look at yourself . Caveat Emptor
FIDELITY RISK PROFILE/ ASSET ALLOCATION LINK (Reviewed 1997, 11//98, 12/00, 11/02- why bother. In less than 5 minutes with 13 questions I was able to calculate my "asset allocation". That's not proper planning. That's a sales gimmick)
PRUDENTIAL RISK ANALYSIS (Reviewed 11//98, 12/99, 12/00, 11/02). Here is what they asked- For each statement, choose the response that most accurately reflects your feelings or behavior. And that's the problem. There are little, if any "feelings" with investments. It's essentially pure research. (I am fully aware of the psychology of investing and know full well that feelings are a main determinant of investing. It's just that it shouldn't be. I have little emotion in reviewing stocks, funds, allocation, etc. My main concern is if I know what I am doing and have I done the analysis definitively.) As regards your prior "behavior", so what. I am concerned about what you need to do and change in the future- not a reflection and continuation of bad history. 13 effectively useless questions designed for a sale, not planning for a future. As of 11/02, you apparently have to be a client in order to get to the risk tolerance section
AMERICAN EXPRESS RISK PROFILE ( Reviewed 7//97, 11/98, 12/99, 12/00, 11/02- 12 Questions to determine your investments for years. Now it is 8 questions. Ridiculous, absurd, stupid)
BANK OF AMERICA RISK PROFILE/ASSET ALLOCATION (Reviewed 11/98, 12/00 11/02. Initially a wasted effort with 12 simplistic questions. Now its 11. They also include this comment which is troubling with every fund- "The overall level of risk you choose is based primarily on your tolerance to assume risk in exchange for potential rewards." The problem is that nobody defines risk and consumers don't have a clue to what they are doing.)
VANGUARD ASSET ALLOCATION: (Reviewed 11/98, 12/99, 12/00, 11/02. They note- Your asset allocation decision will also be influenced by your attitude toward investment risk. Your attitude is important, but perhaps should be overcome by proper planning. That's why you have to read further. What is comical is that Vanguard actually puts the number of minutes before each session of "learning" so you know you won't be there too long. Heaven forbid some intensive effort was required.) They have effectively switched the analysis to Financial Engines
SMART MONEY ASSET ALLOCATION : (Reviewed 12/98, 12/99, 12/00, 11/02. Look at the amount of cash they suggest when you try various strategies and ages. While that certainly limits risk, it tends to simply define what you want to do, NOT WHAT YOU NEED TO DO. Heavy exposure to cash severely reduces your return and it may be that you need to be heavily invested in securities in order to live out your lifetime as you require. Certainly, high cash positions can reflect various market conditions, but I think it just reveals another undisciplined approach to allocation. IT'S THE RETIREMENT BUDGET THAT CONTROLS RISK ANALYSIS).
THIRD AGE ALLOCATOR : (Reviewed 12/99, 12/00, 11/02) It provides four scenarios-
Young,
I've got decades before I retire?
Prime
of life or approaching retirement?
Retiring
soon or already retired?
In
my fourth age, over 70?
But look at the "retiring soon or already retired". I am not suggesting the use of some bonds is not valid, but do you really want 45% in that category? (In 2000- 2003, it is prudent but not simply because you were old. See added comments below) Over the last three years it earned less than 6% annually and was a negative in 1999. Perhaps you can sleep well with about half your portfolio doing dismally, but can your budget??? (2001 Note: Due to the poor economy before the WTC, I changed the bulk of equities over to bonds. That doesn't mean my clients avoided losses up to that point in whatever equities remained. However, I had been reasonably confident that the 7 adjustments by the FED would finally "take hold". Once it became clear that any recovery was NOT going to happen that year, and that further significant losses would occur in the 4th quarter, I made adjustments to fixed income positions which I have kept till current. No, bonds do not outproduce stock over time. But there are certain times they are beneficial and prudent. This is such a time. Always remember 1973/74. Also consider this- per a 11/02 analysis by Deutsche Bank, it estimates there's only a 23 percent chance that U.S. stocks will outperform bonds over the next 20 years. Think hard about what you just read and add it to any allocation you might attempt in the future.)
At age 70, it suggests 60% bonds. But the overriding point may be is that sufficient earning power for a remaining actuarial lifetime of "x" years? (Do you know how long an actuarial lifetime might be at any age????) If you can "guarantee" you will die in 8 years, perhaps 60% in bonds will be adequate. But if you plan on living longer- just your actuarial lifetime of 12+ years for a man and 15+ years for a woman- the static allocation may lead to destitution in the final years of life. Not a good way of leaving the earth when it could possibly be avoided.
Risk is defined either by what you need to do to reach a defined goal- or what you can do if you have more than enough money anyway. Most people's risk scenario is defined by reaching a goal. And that is determined by a budget- A DETAILED BUDGET- for only with that does one really acknowledge how much discretionary money is available- or may be needed- for investing. If that is properly determined, the risk may be far more than originally thought- but absolutely necessary to complete the goal. If you already have excess money, even if invested in the most conservative vehicle(s), then risk is simply what you may desire to take- not what you have to.
An additional element rarely addressed is the fact that once you have a defined budget, you actually need to design a portfolio that returns MORE than what you need. Why is that? Because literally all the formulas are based on a return that never varies- as though that is a reflection of real life fund returns. Not even close. But rather my dealing extensively with the commentary, here is an article by William Bernstein.
All this- and obviously much more- is how risk is determined. But it, categorically, is not accomplished by filling out a form that takes 15 minutes. (Many internet sites and publications use simplistic budgets or "guesstimates" of 50% to 110% of current expenditures. If you want to "guess" about your 20/30 years of retirement, be my guest. But that is exceedingly poor planning.) Admittedly they are not completely useless- few of these forms are totally without merit- but they still border on improper and incomplete planning and can lead to financial disaster since you still have no idea what you really should be doing. It really puts to shame the retirement calculators by most of the major fund firms or the likes of Money, Quicken, Fidelity, Vanguard, etc., etc.
It's even worse with the even more simplistic forms used by the brokerage firms that contain nothing more than four or five boxes where the client checks off "Income", "Conservative", Speculative", etc. There is no way any viable investment can be selected from such a useless input.
All these simplistic forms are designed to make the allocation or investment selection process, easy, quick and painless. It is very rarely quick and invovles a lot of "pain" through years of extensive training and subsequent reading.
Admittedly, not all the forms are so simple. Some go to great lenghts in attempting to describe all types of investments along with the client's "take" on each. Much of this focus is addressed by Roger Gibson, well known in the industry for his work on asset allocation. He noted noted in his book, Simple Asset Allocation Strategies that , "Often, advisers use questionnaires that exhaustively list many different types of investment alternatives. Clients are asked to indicate their familiarity with, preference for, and prior use of each investment alternative. I think it is important to recognize the primary purpose of such questionnaires and to be aware of their limitations.
A client who indicated familiarity with, preference for or knowledge about common stocks, for example, does not necessarily understand them sufficiently to make informed decision regarding their use. At best, such questionnaires are a beginning point for an educational process that meaningfully involves the client. A significant danger exists in inappropriately using the responses to such questions as a basis for either inferring volatility tolerance or building blocks for constructing a portfolio. A client who says he has never invested in bonds and prefers not to use them may only be expressing unfamiliarity with them. I would be inappropriate to develop a portfolio excluding bonds solely on the basis of such a response.
By analogy, consider a person who consults a physician for an ache or pain. The physician will not recommend a course of treatment based on the patient's familiarity with various prescription drugs. Investment preferences are often based on incomplete or erroneous information and should therefore not be used as the basis of a portfolio strategy or assessment of volatility tolerance."
Gibson's commentary accurately reflects the value of the questionnaires that drone on and on in an effort, as I see it, to potentially reduce liability on the planner by (supposedly) exposing the client to all the ranges of risk and letting them pick. It can be a good starting point IF the planner/broker properly utilized the information as a guidelines to more sophisticated analysis. But here is where I take a slight to his analogy. Gibson relates to a patient going to a physician. By inference, the planner/broker is put on the same professional level, expertise, competency and knowledge as a physician. That being a license, degree, years and years of appropriate formal training under closely supervised conditions. Oh sure, there are a few people nationally in the planning or securities field that may match those specifics- but only a few. As stated, brokers have never been taught the fundamentals of investing; designations may be attained in less than a year; there is no formal training program for anyone and no one has to have a degree in any of the subject matter.
In short, the short forms are not worth the time. The long forms might be viable in the hands of a professional, if available. Otherwise, the carte blanche acceptance is unreliable at best.
So, let's take the next step- defining asset allocation. As stated, there are many allocations but they should all address the basic layers of risk. I have one level of risk shown by the "pyramid of investing" and another called the pyramid of mutual funds . These are not cast in stone- they were defined over the years through various economics- and certain revisions may be suggested today.- and certain revisions are necessary today . But the basics are completely relevant- invest in the most risk free areas first before climbing upward on the risk scale. While that should be common sense, it amazes me how many "investors" continually abuse/avoid the basics.
Then there are the "no-brainer" scenarios based on an individual's age (absolutely less risk as you get older). These are acceptable- if you have no idea what you are doing, don't want to know, are too lazy to bother with money or are simply lulled by the marketing hype of the large firms who try to woo you with lots of propaganda as to why and how this is so easy to implement. What should be clear at this point is that I never use these- though I will add this caveat to most of my commentary. If, as stated above, you have no idea what is going on and don't want to and are unwilling to pay someone to actively monitor the assets, you can utilize these scenarios since they tend to keep risk low (though maintaining a portfolio of equities in the 1973/74 ; 2000/2003 market or long bonds in 1994 reflects an INCREASE in risk). That said, remember that they may also keep returns low as well (would you really have wanted 25% in cash and 25% in small cap stocks during the last 10 years?) so you cannot complain when you reach age 70 and find out the allocation was inadequate for your needs. Investment selection/asset allocation are not trivial pursuits consisting of 5 minutes per week of reading by ‘journalists' who are nothing more than money storytellers. Unfortunately, that is what you primarily get with Money, Worth, Smart Money, etc. If you astutely moved money in the recession before you lost substantial sums, my criticism is moot. If you did not, then my commentary for more homework is perfectly valid.
The alternative to simply using pre selected software allocations is to actively monitor the investments (actually the economy). In such case, it is possible to stay relatively fully invested all the way through life. Now, I do agree that if you have a short time frame till money is needed that less stocks should be utilized, but the overall press seems to have forgotten that stock funds tend to produce acceptable returns with LIMITED loss. The trick is to adjust the assets if they really start to tank. The best "real life" analogy, as stated previously, is the 1973/1974/1975 market (have I made that clear yet?) as well as the recent 2000- 2003 mess. Investors lost 40%+ over that short period of time- even more in today's market when involved in the tech market. Neither happened all at once. It was a continual degrading of the markets that, had you used one of the predefined fund allocations (though they didn't exist in the 1970's) or just sat with your stock, I submit that the loss was far more than almost any reasonable investor could stomach. Yes, the market always has come back (at least so far), but it would have taken approximately 12 years for the present value of the stock market gains to have equated to what you could have done had you been invested in Treasury instruments through that period. That's asset allocation at its worst.
How about Emerging funds just a few years ago? I thought they had merit and yes, I did invest some small percentage of portfolios into two managed funds (wanted to make sure Japan was not included and wanted additional diversification). Did they do well?- not after the fiasco in Indonesia that caused worldwide economic havoc. Did I stay in? No- the revised international economy left me uncomfortable at best and I opted out. Did clients lose some money? Yes. Did I refocus and put more funds into the U.S. economy? Yes- and the decision (and returns) have been justified. One could say that investors could stay the course with such "small" amounts of extra risk. But such pundits have forgotten that individual clients- no matter how sophisticated- focus on losses far more than winners. People are a lot more loss averse than risk averse. At least twice. Hence, both from a financial/economic analysis as was well as a reflection of the emotional turmoil, prudent investing suggests changes. That said, there are two caveats. Even with "no brainer" funds, they should be rebalanced for risk at least once per year. Perhaps it might have been possible to limit such losses- but it is my contention that constant monitoring is a valued asset if the person is knowledgeable, has the requisite skills and is constantly reviewing economics. The other caveat is that the no brainer philosophy has worked fairly well for the past 10 years to the third quarter of 2000 in that the recovery of the market has been completed in an extremely short time. Unfortunately for those solely entrenched in past statistics, the recovery has not been quick- hence further and larger losses. It's great to recognize the past- but intensive reading on current economics is mandatory to avoid getting screwed in the future.
My recommendation is to NOT do market timing (doesn't work consistently)- but if the economics have gone so far against the portfolio that a greater than 10% to 15% drop seems apparent (up to that point might be considered simply a ‘correction'), then sell out your most risky asset first keeping your main funds stable. If you have been doing your homework and are UNEMOTIONAL to investing, it is an easy investment philosophy to follow. (See other comments herein called Dollar Cost Averaging Down.) If you are an emotional investor, it's next to impossible to utilize since most investors can't bear to take a loss (See kahneman and Tversky). Or if they do take a loss through a lack of knowledge, they then become unwilling to recommit to the market later on. But that is exactly what is done after a very bad period. If the economics look solid, invest. It almost always works.
To put 2000/2001 into perspective, I made some minor changes in funds that did not do as well as anticipated (basic rebalancing for economics) but I left the core funds alone even though the S&P was down about 20%+ (though I did not put new money into equities). Why didn't I do something more extensive? Because I did not feel that the U.S. economy was truly turning south. Further, I still had faith in the FED.
How did that above statement work as of the beginning for the third quarter 2001? It didn't. After so many interest rate reductions by the FED, nothing was happening- except the economy was getting softer. I did not see any improvement in the economy as of the fourth quarter nor for the first half of 2002. (Remember this was before 9/11 and before any entity had fully declared a recession.) I told clients that nothing more than additional equity losses would occur and that- at a minimum- any tax sheltered accounts should utilize short and medium term bond funds. I did maintain a few equity funds but almost everything else was adjusted. Was I doing market timing? Consider this additional commentary from Bill Jahnke regarding the fees and abilities of those who use static allocations and the element of market timing. There is some additional commentary I also posted.
"As regards financial planners who simply follow the patterns of institutionalized managers, " The consulting community (brokers, planners, et al) had an answer to these questions – job security for the person in charge of the pension fund. By keeping the asset allocation solution close to that of other pension funds, investment performance would not stand out from the crowd. Given that unbridled asset allocation produces wide swings between good and bad times, better to forego some upside return if it meant getting fired when the inevitable period of bad luck occurred.
What many financial advisors learned from these topsy-turvy decades is that portfolio diversification is desirable and trying to call short-term moves in the market is difficult and a major risk to business. What has evolved for financial advisors is an investment solution similar to the one the pension funds came up with a decade or so earlier. Set an asset allocation policy that is middle of the road, but which arguably is consistent with the client’s financial objectives, engage in little or no market timing, and concentrate on selecting good investment managers (in this case mutual funds). Usually this involves selecting a number of funds, which provides plenty of diversification. The financial advisor monitors the funds, making substitutions when a fund stumbles badly enough to be an embarrassment.
There are several problems with this model. One of the biggest problems is the cost. One percent to the financial advisor, one percent or more to the mutual fund, and one percent from the fund to the brokerage community. That’s three percent and three percent is a big drag on portfolio performance, translating to a 50% or more reduction in retirement income for a lot of investors. Another problem is that the asset allocation solution has very little to do with meeting client financial objectives and a lot to do with doing what is currently fashionable. How many financial advisors dare to be under-weighted in technology as we enter the new millennium? (Article before 2000)
To promote their businesses, financial advisors develop marketing and educational programs that appeal to the consumer without painting an accurate picture of the actual limits inherent in investing. Claims about meeting financial objectives and goals have become commonplace in advertising campaigns. Borrowing terms from Modern Portfolio Theory, consumers are introduced to the need to match investment solutions with their “risk tolerance,” which can be conveniently assessed with a “scientifically” constructed risk tolerance questionnaire. Consumers are introduced to what they think are sophisticated investment concepts – such as the importance of setting an asset allocation policy. Investors are warned about the pitfalls of being a market timer and the need to “stay the course” when markets are not performing poorly.
This is where reality gives way to illusion. Regardless of what they say, many financial advisors do not even attempt to match investment solutions with the real financial goals of the client. Managing investments in accordance with an investor’s risk tolerance sounds good but in practice proves to be little more than fitting investors into slots where the asset allocation solutions are established mostly for their marketing appeal and low business risk. Instead of focusing on long term financial goals, risk tolerance is defined in terms of an aversion to portfolio volatility.
The education of investors on asset allocation, market timing, and security selection is often misleading and erroneous, while one of the important determinants of financial success, maintaining an appropriate asset allocation, managing costs, and proper budgeting are ignored or downplayed.
Many financial advisors have no interest in providing active asset allocation services and advertise that they do not engage in market timing. Not only does it have a limited role in determining portfolio performance as demonstrated by the Brinson studies but also it has been shown that market timing reduces portfolio returns over time. Some financial advisors go on to say that market timing is also dangerous, and they point to the potential loss in portfolio value that could happen to the client’s portfolio if the investor happened to miss being in an asset class when it performed well. If this appears to contradict the party line regarding the limited importance of market timing in determining portfolio performance… well, it does.
While it is true that market timing on average does decrease investment returns for investors in general, because of the costs associated with the practice, it is not true that market timing for those engaging in the practice is of limited importance in determining portfolio performance. The more aggressive the market timing, the larger potential there is for a major loss or a major gain in portfolio value. The decision to market time is a very important one and may have big consequences.
Many financial advisors who are unwilling to time the market justify their fees by selecting actively managed mutual funds or individual securities. This inconsistency of providing active security selection while not offering market timing does not appear to trouble them."
Market timing- as I define it- is the attempt to hit the highs and lows of the market. That's pretty nigh to impossible. Adjustments to the portfolio to reflect the risk of the economics is another story. Does it always work and am I always right? Of course not- that's an impossibility. But inherent in the psychology of investors is the absolute fact that a loss is two, three, four times more emotionally debilitating that a the opposite euphoria effect of a gain. Will my adjustments be borne out fully in subsequent years? Difficult to say- but the current lack of equity exposure right now is, I submit, a significant benefit in itself. I can this, though- my clients are far more comfortable with being on the sidelines right now until this economic mess gets cleared. up. I have sent notices to them that I will not engage any changes until I see what the 2002 Christmas spending actually is. The West Coast Port strike could really have messed us up.
Of course, some might say that had I stayed the course via past statistics, a gain was "preordained". After all, consider how fast the market as recovered in the last decade+.
The table shows the recovery of the S& P 500 Index after major losses the past 10+ years.
| Monthly Drop | Following Month | Following 6 months | Following 12 months | |
| Oct 87 | -21.63% | -1.4% | 5.5 | 14.7 |
| Nov 87 | -8.19 | 12.0 | 15.8 | 23.2 |
| Jan 90 | -6.71 | 4.0 | 10.1 | 8.4 |
| Aug 90 | -9.03 | -5.3 | 15.9 | 26.9 |
| Sept 90 | -4.92 | 6.05 | 24.8 | 31.3 |
| June 91 | -4.57 | 7.14 | 14.2 | 13.4 |
| Nov 91 | -4.13 | 9.49 | 12.3 | 18.4 |
| Mar 94 | -4.36 | 2.94 | 5.3 | 15.6 |
| Jul 96 | -4.42 | 7.86 | 24.2 | 52.1 |
| Mar 97 | -4.11 | 12.42 | 26.3 | 48.0 |
| Aug 97 | -5.60 | 1.95 | 17.6 |
I caution you, the past is not a precursor of the future. I would NOT depend on the market being able to continue to do this on an ongoing basis- and as you can see from 2000 to late 2002, the market did NOT do what was, effectively, preordained by the most recent past. I mean, look at the numbers objectively. They were all developed during one of the strongest bull runs ever. The ability to come back quickly was one of the key facets to the great returns. Most returns were out of whack- but a great number of analysts (whoever and whatever they are) got emotionally caught up in a euphoria that has to shut down sometime. That I made "appropriate" adjustments however is not due to some inherent brilliance. It's intensive reading coupled with the real life application such as rebalancing- not a wholesale emergency dumping of everything. Market timing- the effort to find the peaks and valleys of the market place has never worked consistently and no one should try to play that game. But reading almost always works well.
ADDITIONAL RISK COMMENTARY: When viewing any returns in investment allocation, almost all consumers still focus on "pure" or "raw" numbers without qualifying the underlying risk as identified by standard deviation , Sharpe Ratio or otherwise. But I felt this commentary by Marc Hublert- who rates investment newsletters- puts the commentary in proper focus:
He notes that Al Frank "has made more money than any other newsletter since mid-1980, earning a 17.7% return versus the broad market of 16.1% (Wilshire 5000 Index)." But those are just gross numbers of return. They do NOT address the overall risk- meaning a risk adjusted return. Hulbert went on to say that "in achieving those returns, when measured by volatility, his portfolio was two and a half times riskier than the market as a whole". It is not just the return you focus on- "adjusted for risk, Frank's returns lagged the index by 3.5-point percentage points the price paid for focusing on raw, unadjusted performance alone."
When viewing basic allocations- and certainly when using mutual funds- you need to address the issues of hedging with options, currencies plays, margin and other "strategies" used to (supposedly) increase return and work back to what was possible with acceptable risk. You need to know investment fundamentals. And you need to always read and try to interpret national and international economics. If you do not read this stuff, hire someone that does. This commentary- and more- is expanded below.
"BASIC" ALLOCATIONS: In order to put a better and more current focus on various allocations- which normally include cash, domestic bonds (short, intermediate and long term), large and small cap stocks (both which can include subsets of value and growth, etc.), foreign stocks (including even more subsets) as well as slightly esoteric issues such as precious metals, collectibles and so on- I again refer you to the pyramid of mutual funds for a more complete breakdown.
Unfortunately, you can then take these basic sections of the market and develop thousands of different breakdowns. And that is exactly what the various funds families have done- all claiming their allocation will outproduce the other fund families. (I did an analysis of various "retirement" allocations funds by the major fund families several years ago to see if there was any similarity in percentages of classes. Quite interesting and discouraging. Not one of them had literally any relation to the other. (Go to a page analysis of any allocation fund from Morningstar and compare its equities, bonds and cash allocation to other major fund families, load and no load. Bet you will find little correlation.) The managers allocated percentages depending on his/her particular and specific analysis of the groups used and the economics he/she projected. Or they could be designed by the expensive software programs they either bought or developed. No matter- it looks like a crapshoot. I therefore do not believe in them.
As regards the various investment groupings, one needs to reflect on the most current information. I will not address cash since there is not much one can address. That is usually made up of short term instruments (12 months or less) where there may be some difference in yield, but not enough to generate meaningful discussion.
STOCK FUNDS: As regards individual stocks, I have already addressed the statistical risk and the fact that few investors have the insight or knowledge to build a properly diversified portfolio. As regards stock funds, I also need to address the inherent risks - they are not as they appear. It is best to initially provide this paraphrased insight form Nobel award winner Bill Sharpe:
If You Wish to Use a Fund Strictly Within A Class- Do It Cheaply and Efficiently.
Use an Index Fund.
And that dovetails further with research taken from the last 20 years. Managed funds do NOT outproduce the indexes about 80% of the time. Yes, you can find specific funds that will always outproduce the S&P- or whatever index you are comparing against- for a year's period of time, but they, almost universally, will not outproduce the index the next- or certainly the years after.
Cavanaugh Capital Management
Even if a fund did do better, it almost assuredly was with more risk. Look at Janus- in fact, look at any tech funds returns for years. Many had perhaps beaten the S&P index, but the fallacy of investors was that they could NOT compare the two to each other since the risk scenarios were decidedly different. Look at 2000. The S&P is down- but the NASDAQ has been clobbered. You must address risk in any analysis. As for those that now feel in early 2001 that managed funds will outproduce index funds, I suggest you review this article by Cavanaugh Capital Management.
But there is more to it than just the pure statistics. It's the real life scenarios focusing on the changes in managers and management style as more sophisticated reporting came into being via the computer and internet. In example one, managers that might be inclined to hold onto strategies that might slow growth NOW in the hopes of renewed profitability in the future are immediately compared to the index and might not be given a chance for future success. Just look at the Fidelity Magellan. When Jeff Vinik held onto bonds while the market was going up, he was effectively vilified by literally the entire press as well as all Magellan's investors. While he may have quit- he didn't have much choice. In example 2, you might remember the John Hancock Special Equities averaged 18.5% over the last ten years but had moved wildly in doing so. It returned a negative return in the beginning of 1998 and the manager was fired. And the scenarios are similar at other mutual fund companies. Either produce or you are gone. If he/she uses greater risk to beat the market, (s)he's a winner, irrespective of risk. But if he falters, it's an end game. And even if he/she is conservative in waiting out a market, the instantaneous reporting (say by the likes of Morningstar which will drop his star ranking) means that he loses investors and perhaps his job. The ability for a fund manager to "stay the course" to beat an index may be limited at best.
INDEX FUNDS: I do NOT promote the sole focus on index funds- but one is hard pressed not to utilize them as the initial platform before the use of actively managed funds. Unless one is a very astute investor with a considerable understanding of economics, indexing should consist of about 75% of asset allocation.
Indexing as % of Equity Assets
($ Billions)
source- Vanguard
| Private and Public Pensions | Mutual Funds | Total Pensions and Funds | U.S. Stock Market | |||||
| Indexed Dollars | % of Assets | Indexed Dollars | % of Assets | Indexed Dollars | % of Assets | Indexed Dollars | % of Assets | |
| 1985 | $90.6 | 14.7% | $.6 | .5% | $91.2 | 12.4% | $2,195.0 | 4.2% |
| 1990 | 172.7 | 20.2% | 4.9 | 2.0% | 177.6 | 16.2% | 2,957.6 | 6.0% |
| 1993 | 293.0 | 19.9% | 23.3 | 3.4% | 316.3 | 15.1% | 4,791.0 | 6.6% |
| 1997 | 672.0 | 21.9% | 141.7 | 7.2% | 813.7 | 17.0% | 10,271.0 | 7.9% |
There are even caveats here since an index in the Pacific rim contained a large percentage of Japan which had been in the doldrums for years. I will repeat this commentary- investing, including any element of asset allocation- without an extensive and continual focus on economics is a fool's game. (Admittedly, even then the experts may vary- as seen in the prior commentary on the huge disparity in allocations in the Retirement funds. Nonetheless, I submit that a constant review would help one keep investing in focus and avoid the catastrophe's of 1973/1974.) And for the stalwarts of managed funds, here is some commentary on how index funds can BEAT the index.
INSTITUTIONALIZATION OF THE MARKETPLACE: Why such a change from past history where some managers had been able to outperform the market? It's the institutionalization of the entire marketplace. Forty years ago, institutions held less than 10% of the outstanding shares and individuals held more than 90%. Now, however, institutions- pension funds, mutual funds and insurance companies- hold more than 50% and have split up their shares of ownership quite dramatically from the 1970's. And according to two professors, "big investors act differently than individuals". Click to go to the downloadable article by Gompers and Metrick (Adobe Acrobat)
(Institutional Investment Report, 6/98)
| Type of Institution | 1970
(Billions) |
% 1970
Assets |
1980
(Billions) |
% 1980
Assets |
1990
(Billions) |
% 1990
Assets |
1997
(Billions) |
% 1997
Assets |
| Pension Funds | $231.1 | 31.7 | $859.2 | 45.5 | $3,124.5 | 49.4 | $6,757.1 | 47.3 |
| Private Trusteed | 112.0. | 16.7 | 504.4 | 26.7 | 1,668.0 | 26.4 | 3,577.8 | 25.1 |
| Private Insured | 40.8 | 6.1 | 158.2 | 8.4 | 636.1 | 10.1 | 1,079.6 | 7.6 |
| State & Local | 60.3 | 9.0 | 196.6 | 10.4 | 820.4 | 13.0 | 2,099.7 | 14.7 |
| Investment Companies | 47.6 | 7.1 | 118.0 | 6.3 | 967.3 | 15.3 | 3,112.7 | 21.8 |
| Open End Mutual Funds | 47.6 | 7.1 | 113.0 | 6.0 | 914.6 | 14.5 | 2,959.0 | 20.7 |
| Closed end | n/a | n/a | 5.0 | 0.3 | 52.7 | 0.8 | 153.7 | 1.1 |
| Insurance Companies | 225.1 | 33.5 | 518.7 | 27.5 | 1,328.4 | 21.0 | 2,399.1 | 16.8 |
| Life Insurance | 166.5 | 24.8 | 321.0 | 17.0 | 772.1 | 12.2 | 1,530.5 | 10.7 |
| Property & Casualty | 58.6 | 8.7 | 197.7 | 10.5 | 556.3 | 8.8 | 868.6 | 6.1 |
| Bank and Trust Companies | 186.8 | 27.8 | 342.2 | 18.1 | 759.1 | 12.0 | 1,742.9 | 12.2 |
| Foundations | n/a | n/a | 48.2 | 2.6 | 142.5 | 2.3 | 270.2 | 1.9 |
| All Institutions | $672.6 | 100% | $1,886.3 | 100% | $6,321.8 | 100% | $14,282.0 | 100% |
and also from "How Are Large Institutions Different from Other Investors? Why Do These differences Matter?" by Gompers and Merrick.
| Banks | Banks | Insurance Co. | Insur. Co | Mutual Funds | Mutual Funds | Investment Advisers |
Invest. Advisers | Other (Univ. Endowments | Other | Total | |
| # Of Institutions | % of Total | # Of Instit. | % of Total | # Of Instit. | % of Total | # Of Instit. | % of Total | # Of Instit. | % of Total | # of Inst. | |
| 12/80 | 216 | 41.1 | 65 | 12.4 | 47 | 9.0 | 122 | 23.2 | 75 | 14.3 | 525 |
| 81 | 215 | 38.5 | 60 | 10.8 | 51 | 9.1 | 150 | 26.9 | 82 | 14.7 | 558 |
| 82 | 216 | 37.4 | 60 | 10.4 | 52 | 9.0 | 172 | 29.8 | 78 | 13.5 | 578 |
| 83 | 226 | 35.4 | 63 | 9.9 | 52 | 8.1 | 218 | 34.1 | 80 | 12.5 | 639 |
| 84 | 225 | 32.5 | 63 | 9.1 | 51 | 7.4 | 266 | 38.4 | 88 | 12.7 | 693 |
| 85 | 224 | 29.2 | 69 | 9.0 | 54 | 7.0 | 332 | 43.3 | 87 | 11.4 | 766 |
| 86 | 208 | 25.8 | 65 | 8.1 | 60 | 7.4 | 379 | 47.0 | 94 | 11.7 | 806 |
| 87 | 211 | 24.0 | 72 | 8.2 | 58 | 6.6 | 441 | 50.1 | 99 | 11.2 | 881 |
| 88 | 214 | 24.3 | 62 | 7.0 | 58 | 6.6 | 454 | 51.6 | 92 | 10.5 | 880 |
| 89 | 218 | 23.3 | 69 | 7.4 | 54 | 5.8 | 506 | 54.0 | 90 | 9.6 | 937 |
| 90 | 216 | 22.1 | 73 | 7.5 | 57 | 5.8 | 541 | 55.4 | 89 | 9.1 | 976 |
| 91 | 212 | 21.1 | 70 | 7.0 | 56 | 5.6 | 584 | 58.1 | 83 | 8.3 | 1005 |
| 92 | 216 | 19.7 | 70 | 6.4 | 63 | 5.7 | 666 | 60.7 | 83 | 7.6 | 1098 |
| 93 | 191 | 18.5 | 64 | 6.2 | 61 | 5.9 | 649 | 62.8 | 69 | 6.7 | 1034 |
| 94 | 195 | 17.2 | 75 | 6.6 | 54 | 4.8 | 740 | 65.2 | 71 | 6.3 | 1135 |
| 95 | 202 | 15.5 | 78 | 6.0 | 96 | 7.4 | 845 | 65.0 | 79 | 6.1 | 1300 |
| 96 | 172 | 13.2 | 69 | 5.3 | 90 | 6.9 | 900 | 69.1 | 72 | 5.5 | 1303 |
And another from John Bogle:
Assets Held by the Three Major
Institutional Pools
| Corporate Retirement Plans | State and Local Retirement Plans | Mutual Funds | Total | |||||
| $ Billion | Percent | $ Billion | Percent | $ Billion | Percent | $ Billion | Percent | |
| 1983 | $350 | 68% | $90 | 17% | $79 | 15% | $519 | 100% |
| 1990 | 562 | 51% | 293 | 27% | 249 | 23% | 1,104 | 100% |
| 1993 | 938 | 45% | 531 | 25% | 634 | 30% | 2,103 | 100% |
| 1996 | 1,422 | 37% | 956 | 25% | 1,514 | 39% | 3,892 | 100% |
| 1998* | 2,005 | 34% | 1,482 | 25% | 2,396 | 41% | 5,882 | 100% |
*First quarter.
According to an article by the professors, institutions bought larger companies where their power could be felt (witness the activity of California Pension Funds over the last five years.) And it may be here why so many of the more costly companies have been doing so well- and certainly at the expense of small cap stocks which have not seen a strong market for around 15 years. Is it a trend that will continue? No one knows. But also in this equation is the fact that many economists thought small cap companies could take advantage of technology much faster and earn that much more than the mammoth firms. True- but Greenspan noted that technology developments in national economics takes a long time before it gains a foothold in manufacturing and other areas (think of electricity, radio, television, internet). Perhaps the larger companies are now coming into their own regarding the computerized industry and are having a slight advantage over their stodginess of prior decades. If so, the higher valuation and the higher returns might actually be justified and at the expense of higher returns for small companies- but only more time can tell. Even so, one also needs to address the larger companies of the U.S. versus the large international companies. The U.S. still leads, is still the innovator and, irrespective of the political messes the politicians can concoct, it has Greenspan and the FED which has been able to, and I think will be able to continue to, control the economy with reasonable growth and low inflation. And be advised- the low inflation is a key to U.S. continued development. (Actually any country. But low inflation of 2%+ is not necessarily low inflation for developed or second or third world countries- it could be 10%.)
NEW FUNDS: Most allocations use funds that have been tested for a number of years. However, there has been significant commentary that utilizing a new fund might ring BIG returns- at least for the short term- since the fund might be able to pick just one or two issues that provide big returns. But recent studies don't seem to support that. They do show that about one-third of the best performers were actually funds started in the past three years. But about one-third of the WORST performers were rookie funds, too. Of course, you can rebalance to try and pick these (supposedly) top performers, but the time involved in the research and the tax consequences on any gains tends to negate any consistent opportunities. (The Von Waggoner funds come immediately to mind as to the problems of a "brilliant" manager starting his own firm, making a bundle, then tanking big time. He has come back (and forth) but the volatility is enormous and the returns over time still low as of 4/99).
In addition to using some new funds is the basic formula of "adding" some percentage of small cap, real estate, international funds and others such as gold, oil stocks, etc. The intent is to "hedge" the movement of one class of equities to another. But as Robert Markham noted, "Under the tyrannical lash of modern portfolio theory and the efficient frontier, the sensible practice of portfolio diversification has been pushed to illogical extremes. As a result, investors have been lured into using one class of stocks to hedge against another class of stocks, a move that is doomed to failure."
SMALL CAP FUNDS: They noted that the "increasing influence of institutional investment behavior may have played a role in the recent disappearance of the returns previously earned by small cap stocks". Here is some further commentary on what has happened with small caps since around the early 1980's. And as already commented upon, the institutional investments have focused on larger companies with higher valuations. They also noted a specific reference to the fact that the largest 100 institutions have unquestionably preferred the larger more liquid shares of larger companies. And they noted that there is nothing on the horizon that lead them to believe that the focus will change. Add in the fact that there are far more analysts and researchers of every type researching every company, even small cap stocks do not escape an analysis that is far more intensive than of past years (if many of the firms were reviewed at all.) The "undiscovered jewels" of the past probably are limited.
INTERNET STOCKS: I can't add much that has not already been addressed in numerous articles regarding the ungodly premiums paid over any legitimate valuation via P/E ratio. They should not hold up over time (it reminds me of the fool's game in real estate in the 80's before the Resolution Trust debacle. It reminds me now of the real estate overvaluation in Japan and the huge losses suffered by its banks.) If you (still) have discretionary money and want to play the game, fine. You might win a lot- but if it goes bust, you have a lot of exposure. Regardless, major plays focusing on this high risk area is not asset allocation. (Additional note: The above commentary was made BEFORE the tech meltdown in 2000. I assume you are clearly aware of what has happened since. This comment is not to show that I was "smart" in recognizing its problems- just that when the fundamentals are violated, a setback of some magnitude is literally preordained.)
FOREIGN STOCKS: Developed above in regards to hedging, I will add a further commentary to allocation. They should be considered as part of proper allocation- but not in a vacuum as some fund computer analysis would determine. Go back to 1994 when we had a drop in the market due to the FED's 5 time hike in interest rates. Article upon article suggested a move to international stocks. Yet separate economic articles clearly identified the U.S as having the most solid economics, low inflation, a projected solid/reasonable growth, stable politics, etc. Even a later 1998 Business Week article noted that the "conventional wisdom has been that foreign growth would be the driving force for the profits and returns in the future" and then went on to say that it hasn't produced the returns expected and the U.S. might have been- and is- the place to be. So, my allocation simply reflected a very strong position to larger U.S. companies using index funds or those funds with a very low turnover and a heavier focus on technology. (I am not suggesting that readers take the same focus, but the great emphasis on fundamentals and a slightly skewed "real life" allocation made a lot more money than those standard allocations heavy into foreign funds, precious metals and the like.)
An additional commentary : One author in foreign investment strategy states that there really is NO diversification in the use of foreign investments since they are directly correlated with U.S. stocks. This goes against almost all comments on asset allocation and the use of random or negatively correlated investments. As proof however, he also pointed out that, except for Japan, the EAFE index turned in an average exactly that of the U.S. market in the 1968- 89 (though simply having the same return says nothing about correlation per se). He also noted that costs for investing are also higher (witness the higher expense ratios in any of the foreign mutual funds). Further commentary noted that indexing therefore was a waste of time since you are looking for the inefficiencies of the foreign markets on which to make a gain. Possibly and probably true, but is it now possible to research and find the inconsistencies with all the analysis and reporting? Or might such inconsistencies and the selection thereof amount to luck? Do not mistake my comments- I am not stating that anything might not be possible. But do not dismiss the fact that higher returns might not be due just to happenstance and not able to be reproduced.
CURRENCY HEDGING: - As subsequent tables will show, once a foreign currency revalues, it can severely decimate the US dollar return- your ultimate return. So, how about hedging for such contingency? Sounds reasonable until I read articles by the FED that said there was NO correlation with a foreign currencies movements and it previous economic tribulation.
MSCI EAFE
| % Change on August 12, 1998 from | US$ | Local Currency |
| 12/31/97 | 7.8% | 10.5% |
| 12/31/96 | 8.0 | 23.5 |
| 12/31/95 | 12.8 | 35.4 |
| 12/31/94 | 23.4 | 45.8 |
Look at 12/31/94. You supposedly made 45.8% over time but, almost assuredly, the rise of the dollar against the various foreign currencies dropped the return to 23.4%. That's about a 50% drop. Hedging against the dollar would have produced higher net dollar returns (at a cost), but no one can tell me that the dollar was expected to be that strong. What if the hedging had been exactly the opposite anticipating a lower dollar?? My point is that there, apparently, is no correlation to really know what will happen. Check out the next table:
MSCI Pacific (Developed)
| % Change on August 12, 1998 from | US$ | Local Currency |
| 12/31/97 | 16.1% | -7.15% |
| 12/31/96 | 38.2 | -22.7 |
| 12/31/95 | 44.0 | -28.6 |
| 12/31/94 | 43.0 | -20.2 |
During this period, the dollar gain was exactly the opposite. What happened if you paid for hedging that provided no return? Just the fact that you had a loss for costs associated therewith.
And here are a couple more where you can make your own decisions.
MSCI Emerging Markets
| % Change on August 12, 1998 from | US$ | Local Currency |
| 12/31/97 | -28.2% | -22.6% |
| 12/31/96 | -39.0 | -21.4 |
| 12/31/95 | -36.5 | -12.9 |
| 12/31/94 | -43.3 | -18.3 |
MSCI Emerging Markets Far East
| % Change on August 12, 1998 from | US$ | Local Currency |
| 12/31/97 | -33.5% | -30.2% |
| 12/31/96 | -71.3 | -55.1 |
| 12/31/95 | -70.6 | -53.5 |
| 12/31/94 | -70.8 | -53.4 |
MSCI Emerging Markets Latin America
| % Change on August 12, 1998 from | US$ | Local Currency |
| 12/31/97 | -31.7% | -26.3% |
| 12/31/96 | -12.4 | -0.8 |
| 12/31/95 | 4.2 | 23.6 |
| 12/31/94 | -11.5 | 24.7 |
BONDS: Bonds, for the most part, are not investments per se. (I am not making reference to non diversified holdings with low ratings, foreign bonds or long term bonds held for the singular purpose of appreciation.) They are primarily income producing securities that reflect a need by the owner for income or, in the alternative, a reduction in risk to other ownerships of stocks since the consistent (normally) returns offset the minimal dividends of most stocks. Even if viewed as investments, bonds do not carry the risk aversion touted in past text books. (Click here for a description of yields, maturities, duration and more) Volatility has been quite extensive- particularly during the lowering of interest rates from the 1980's. However, they will not provide the double digit return of that in the late 80's and early 90's. That was due almost solely to the fact that interest rates had been as high as 15%+ and, as the FED reduced inflation and interest rates overall, bond principal value increased. (Make sure you understand the inverse movement of bond principal to interest rates. It's crucial to any allocation.) Nonetheless, now that rates are so low, they cannot be expected to really go lower and therefore should be looked at as simply producing yield. (I am not addressing high yield bonds which, due to the lower rating, tend to act more like small cap stocks than an income producing investment and can show far greater volatility.) A further commentary to increased risk in bonds is the supposed "ability" of funds and managers to hedge various positions of stocks AND bonds (playing arbitrage) that has created abnormalities not found in the past. This is "best" shown by the recent debacle of Long Term Capital and the use of "can't fail" computer programs. It shows that when things REALLY go bad, the unwinding of sophisticated instruments can cause the FED to be involved in a wholesale bailout of stocks and bond positions. Liquidity was reduced tremendously in the marketplace and the value of many bonds was significantly reduced. (Remember, liquidity and marketability in the market may be synonymous- but is NOT guaranteed. You almost always can get liquidity- but it can be at a lower price. See my glossary for a detailed description.) So, if you use bond funds, the gains of past years is probably not possible. Yet higher volatility exists than what existed in the 70's and early 80's. However since the managers of large funds are highly diversified, the volatility of a fund might be less than individual ownership of just a few non liquid issues. Owners of individual securities may not be that concerned with volatility if the intent is to hold the bonds to maturity (though the call dates need be addressed separately). In that case, and if one is assured that NO intermediate sale is needed and a rating change will NOT occur (an impossibility), then the use of individual bonds might be better use in the allocation.
As an expansion to the above commentary for bond and altered allocation profiles is the period from the mid 80's to the mid 90's when interest rates were declining. At such time, and pursuant to the expanded position by the FED to reduce interest rates and inflation, I opted for a significant portion of long term bonds- far more than any stated in text or elsewhere- since they would (as long as the rates declined) provide significant returns with very limited risk exposure. (Remember that bonds can increase in value as rates drop. And the longer the maturity date, everything else being equal, the greater the increase. Bond returns in 1986 and 1987 alone were 18%+) As a result, clients made 12%+ in many years in just the bond allocation . While not the same return as stocks, it was made with- in my estimation and because of my reading- about 50% LESS risk. On a risk adjusted basis, the return far exceeded equities. However, once 1994 entered the picture, the increase in interest rates created far more losses for bonds- specifically for longer terms- and I had to shorten maturities accordingly. (They were a small part of the equation allocation since I opt for monitoring of the assets regardless of age. But once 2001 and the mess of the recession, I opted for a stronger position in bonds.) I am NOT suggesting that was the best strategy for everyone- merely indicating that static allocation profiles would not have included that type of latitude. You make your own decision as to whether the allocation was valid.
As regards foreign bonds, it is true that allocations may suggest their use. But considering the currency concerns, most analysts suggest that if you are going overseas, why not simply go for the (potentially) greater return with equities first and foremost. The point being that if you are going to take an equal amount of risk, you might as well opt for the potentially greater return unless economics clearly dictate otherwise.
REAL ESTATE: In years past, there were extremely limited opportunities in using real estate in a portfolio. Limited partnerships still pr