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Wednesday, July 15, 2009

Doubts about Asset Allocation

There's definitely been a recent bunch of articles about the so-called failure of asset allocation. I'm amused and horrified at the same time. My amusement comes from the use of the last 2-3 year's worth of results to argue that the past 70 years or 100 years of studies on asset allocation are invalid. As I've pointed out, financial planning is a multi-decade process! The only reason why equities can perform as well as they do is that once in a while you get a really good buying opportunity, and if you don't rebalanced into that opportunity when the time comes, don't expect your results to be any good!

My horror stems from the idea that this would lead folks to jump off their financial plans. Now this is understandable. It's very easy to say, "I'm willing to tolerate a 50% drop in my equity portfolio" when times are good. It's another to actively rebalance into that same losing portfolio when times are terrible. The last few years have been tests of conviction for those who might have been uncertain about what their risk tolerance is.

In 2007, when William Bernstein visited Google, he made the point that during a financial crisis, all assets correlate to 1. In other words diversification fails you when you need it the most. But that's why you don't put everything in stocks --- even if in a financial crisis, your bond portfolio takes a hit, it's not as big a hit as it is in stocks. And you do want to position yourself for when the correlations are not 1 --- i.e., when the crisis is over. The unfortunate problem is that nobody knows when that is, so the best plan, as always, is to stick to your asset allocation.

3 comments:

PT said...

Just don't blindly use historical returns and correlations to OPTIMIZE your asset allocations. The data is not accurate enough and the underlying assumptions and economic situations change over time. Furthermore, in a crisis, when correlations go to 1, variances blow up. There is no free lunch.

Silicon Shadow said...

I agree -- i'm similarly horrified by the repeated "failure of asset allocation" style articles or tv propaganda blitzing the media these days. I see it almost daily. I even fight with it on a personal level as my gf seems convinced of its failure as well. In her case she cites the fact that its been over a decade and she's down overall -- thanks to declines in 2000 and 2008. I am pretty sure she doesn't rebalance properly, but explaining that has proved... difficult.

Never the less, I feel like the financial news media is really just a FUD spewing machine to get people to hang on their words like they matter. Once you free yourself from the idea that they do -- financial planning the right way, is much simpler than most people realize.

Wayne said...

Asset allocation rebalancing is too difficult for most investors. In good times they can't bear to let go of the the up sectors and in bad times they are too afraid to buy into the down sectors.

I see a lot of investors actually doing the opposite of proper asset allocation rebalancing. This occurs as they follow the up sectors always balancing toward the winners. In an up market this appears to yield favorable results and they cannot be convinced of the need to rebalance. In a down market fear drives them to move away from the down sectors.

Asset allocation is a good but very difficult strategy. I know very few people that have the needed self discipline and self awareness to stick with it or the paid advisors that pursue it.