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The Asset Allocation Bell Tolls

July 19th, 2009 by 
PK

The way the financial community seems to be covering it, we are currently attending the funeral of Asset Allocation.  Long live Asset Allocation!

A common topic on financial pages world wide web wide (a cheer for alliteration?) is about the supposed death of asset allocation.  Asset Allocation is the idea that the best retirement play for most investors is to allocate financial resources among a number of investment baskets.  Supposedly by spreading one's investments across a diverse set of asset classes it is possible to catch the hot performance in any corner of the market while absorbing any shocks in other corners.  Of course, the uninspiring performance of asset classes during the 'Great Recession' seem to throw this theory into question.  Read on and decide for yourself if we need to find some pallbearers for this financial heavyweight.

Chicago School and the Efficient Frontier

Asset Allocation: Wikipedia Image of the Efficient Frontier

Wikipedia Image of the Efficient Frontier

The economist most associated with Asset Allocation is 1990's Nobel Prize winner Harry Markowitz.  Markowitz studied economics at the renowned University of Chicago under lots of economics heavyweights.  Milton Friedman, as Markowitz recalled in his Nobel Prize acceptance speech, even went so far as to say that Markowitz's explorations into portfolio allocations weren't economics.  Regardless, Markowitz gave his name to the Markowitz (also known as efficient) Frontier.  Modern Portfolio Theory states that the Markowitz Frontier is the point when a portfolio cannot lower its risk (through diversification) for a given rate of return.

Modern Portfolio Theory is really an outcropping of another idea that came out of the Chicago School (specifically Eugene Fama)- the Efficient Market Hypothesis.  The Efficient Market Hypothesis states that when information relevant to a security is disseminated, prices will adjust and price that news perfectly.  The EMH is a purposeful simplification framing the discussion for finance classes- not an actual description of the stock market.  (Here's a good post describing the distinction)  Regardless, the takeaway point is that most investors will not beat the market in any sort of an active trading roll.  (The best summary of why the EMH can't be true all the time takes the form of this sidewalk joke:

"An economics professor and his student are walking down a sidewalk when the student bends over to pick up a twenty-dollar bill.  The professor stops him before he can grab it and says, 'that can't possibly be a real twenty dollar bill; someone surely would have picked it up by now!'" )

Plunging Markets

In a quickly falling market, the correlation of most assets actually increases.  This is a strange side effect of quick selling which also manages to turn Asset Allocation on its head.  All of the carefully diversified asset classes investors in the AA system bought into years ago (and rebalanced often) all fell simultaneously.

As you can see, commodities seemed to be uncorrelated with the index.  Suddenly, they started to look a lot like stocks and fell just as quick.  Note that 'risk' in Modern Portfolio Theory is approximated using standard deviation of returns, a backwards looking indicator.  There are other ways to look at risk... implied volatility of options, for example.  Regardless, there is no way to completely know the risks before a scenario like a 'Great Recession' happens.

The Nail in The Coffin for Asset Allocation?

Does this convincingly prove anything about the demise of Asset Allocation?

Of course not.  Lots of investing styles lost money in the recession... Warren Buffet's value investing style (using Berkshire Hathaway as an example) even lost money.  There are also some asset classes that did well throughout the downfall of the stock market, like government debt.  Perhaps the issue isn't a failure of Asset Allocation, but an improper selection of the asset classes which investors put their money into (a mistaken belief that certain classes would stay uncorrelated, even)?

I firmly believe that most investors are best off using the simplest possible methods to invest on their own.  Diversification, which is the key to a theoretically sound asset allocation, is key.  Most people don't have the energy or the inclination to put in the sort of work successful active investing takes.  Asset allocation is a way (sort of like dollar cost averaging) for average people to sock some money away.  On this merit alone I feel AA is still alive.  Much like any movement (take the infamous Business Week cover, "The Death of Equities") which declares something in investing dead, this too shall pass.  Perhaps the issue was the over-adoption of the strategy?  As Felix Salmon states in his take on AA's demise:

"It’s a pretty solid rule of investing: good ideas tend to become broadly adopted. And once enough people are all doing the same thing, that thing is probably not a good idea any more but rather a bad idea."

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