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.
Post a Comment