Toward a New Concept of Asset Allocation 26 comments
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Longtime readers know that I am not a fan of modern portfolio theory. It is a failure for many reasons:
- It assumes there is one type of risk, the occurence of which is random.
- It assumes that this risk can be approximated by volatility (variance of returns), rather than probability of loss, and the likely severity thereof.
- Mean return estimates, volatility estimates, and correlation coefficient estimates aren’t stable.
- In crises, correlations head to 1 or -1. Assets divide into safe and “not safe.”
- Problem: some assets always fall into the “not safe” bucket, but what falls into the safe bucket can vary. Long Treasuries and commodities could be examples of assets that vary during a crisis, depending on the type of crisis.
- It does not recognize multiple time horizons easily. Bonds held to maturity have a different risk profile than a constantly rebalanced portfolio.
- Risk is the same for all people, and their decision-making time horizons are the same as well.
- And more…
I’m still playing around with the elements of what would make up a new asset allocation model, but a new model has to disaggregate risk into risks, and ask some basic questions:
- Where am I getting paid to take risk?
- Where am I getting paid to avoid risk?
- What aspects of the financial landscape offer the potential for a change in behavior, even if it might take a while to get there? What major imbalances exist? Where are dumb people making money?
- Where options are available, how is implied volatility relative to long-term averages?
- What asset classes have momentum to their total returns?
One good example of an approach like this is Jeremy Grantham at GMO. Asset allocation begins by measuring likely cash flow yields on asset classes, together with the likelihood of obtaining those estimates. With domestic bonds, the estimates are relatively easy. Look at the current yield, with a haircut for defaults and optionality. Still there is room to add value in bonds, looking at what sectors are cheap.
- Are corporate spreads narrow or wide?
- How are residential mortgage bonds priced relative to agency bonds, after adjusting for negative optionality?
- How steep is the yield curve, and where is Fed policy?
- What is the speculative feel of the market now? Bold? Scared? Normal?
- Related, how are illiquid issues doing? Are they permafrost, or are molasses not in January?
- If every risk factor in domestic bonds looks lousy, it is time to make a larger allocation to foreign bonds.
- Cash is underrated, and it is safe.
Understanding bonds is an aid to understanding the rest of the market. The risk factors in play in the bond market are more transparent than elsewhere, but the rest of the markets eventually adjust to them.
With stocks and commodities, the answer is tougher — we have to estimate future demand and supply for commodities. Tough. With stocks, we need to estimate future earnings, and apply a P/E multiple that is consistent with the future yield on BBB corporate bonds. There is some degree of mean-reversion that can help our estimates, but I would not rely on that too heavily.
There is one more aspect to layer in here: illiquidity of equity investments. With limited partnerships of any sort, whether they are hedge funds, venture capital, private equity, etc., one has to analyze a few factors:
- Where is the sector in its speculative cycle? Where are secondary interests being sold?
- How much capacity do you have for such investments? How much of your liability structure is near-permanent? Is the same true of peer institutions?
- Is the public equity market overvalued or undervalued? Public and private tend to track each other.
Beyond that we get to the structure and goals of the entity neding the assets allocated. Time horizon, skittishness, and understanding levels are key for making a reasonable allocation.
This is just my initial brain dump. It was spurred by this article in the WSJ, on how asset allocation had failed. Add in the article on immediate annuities, which are a great aid in personal retirement planning. For those that think that immediate annuities reduce the inheritance to the children, I would simply say that it is longevity insurance. If the annuitant lives a long time, he might run out of assets, and might rely on his children for help. The immediate annuity would be there to kick in something.
Why did asset allocation fail in 2008? All risk assets failed. Stocks, corporate bonds, venture capital, private equity, CMBS, RMBS, ABS… nothing held up. There were just varying degrees of loss. Oh, add in Real Estate, and REITs. Destroyed. Destroyed…
When the system as a whole has too much leverage, all risky asset classes get affected. That’s what happened in 2008, as speculators got their heads handed to them, including many who did not realize that they were speculators.
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This article has 26 comments:
Simplistic risk buckets spit out a mix of stocks and bonds for "aggressive" investors, "conservative" investors, and everyone in between. These tools would now reflexively put a conservative investor in long-term U.S. government bonds. Unfortunately, duration risk makes this a very risky investment vis-a-vis inflation and long-term purchasing power.
And, as you noted, cash is continually undervalued as an asset class. Banks, brokers, and financial advisors do not earn a fee on cash assets under management, and this contributes to its neglect as an asset class.
Rob
What do you think of Bill Luby's idea of using the VIX as a diversification tool? The logic seems to fit your paradigm.
Rob
seekingalpha.com/artic...
Thanks for the great article
Can asset allocation work in a market that is run so much by computer now, coupled with borrowed and highly leveraged money?
Just dont know
compdivplan.com
Specifically, the article notes "Cash is underrated, and it is safe.", and that "In crises, correlations head to 1 or -1. Assets divide into safe and 'not safe.' ". I don't know about you, but I've certainly learned this lesson the hard way over the past year.
You'd think such wisdom would be common-sense by now, but I *still* see advice all over the place suggesting that you can "diversify" simply by owning a mix of equities, all of which will inevitably fall down whenever the next bubble bursts.
One timely example of this advice: a recent Motley Fool article proclaiming "These 5 ETFs are All You Need" ( www.fool.com/investing... ). The word "cash" is not mentioned anywhere in this article. Instead, the authors espouse wisdom such as "Investors with long time horizons might choose to skip bond exposure and invest solely in stock funds". Apparently, the authors were asleep for the entirety of 2008.
There are far too many investors (speculators?) who think that a portfolio consisting primarily of equities, perhaps with some corporate bonds thrown in the mix, is a tenable long-term investment for the bulk of their funds. I'm not making that mistake with my money.
> Banks, brokers, and financial advisors do not earn a fee on cash
> assets under management, and this contributes to its neglect as an > asset class.
This is not always true, but you made some other great points. Many RIAs DO charge on total asset base including cash. The justification is if the advisor is making a tactical cash bet then it is a "managed" asset.
You beat me to the inflation argument on cash - a good point.
I'll take a shot at treasuries. While these would normally be considered "safe" because of their non-existent default risk, the yields are so low right now that they carry a huge risk of declining in value as interest rates rise and inflation picks up.
So, it appears that no asset is truly risk-free, so we might as well get used to it.
A professor once told me there is one thing he knows about his models “they are all WRONG but I think I understand the problem better now that I have a model.” Once we take the human aspect out of a model then its dangerous.
Just buy when there is blood on the floor, and sell when the taxi driver gives you tips. Keep it simple IMO.
> Just buy when there is blood on the floor, and sell when the taxi
> driver gives you tips. Keep it simple IMO.
Excellent advice! Case in point: gold. I see tons of signs that say "Cash for your gold!" I see TV commercials that point viewers to cash4gold.com. When I see signs that say "We Sell GOLD!" and TV commercials pointing me to gold4cash.com, I know that investment gold has reached its top (what I'll call "insurance" gold always gets kept, though).
SHOULD WE HAVE ENDOGENOUS MONEY, YOU WOULD NEVER EVEN ASK YOURSELF THESE QUESTIONS. THINK ABOUT IT.
HERE IS A HINT: DO YOU THINK THAT, UNDER A GOLD STANDARD (do not confuse it with gold-exchange standard) YOU WOULD EVER SEE AN INVERTED CURVE ON A BENCHMARK ASSET? WHY?
I think that has more to do with taking advantage of unemployed cash strapped consumers
On Jul 10 02:05 PM Carlos Lam wrote:
> Excellent advice! Case in point: gold. I see tons of signs that say "Cash for your gold!" I see TV commercials that point viewers to cash4gold.com. When I see signs that say "We Sell GOLD!" and TV commercials pointing me to gold4cash.com, I know that investment gold has reached its top (what I'll call "insurance" gold always gets kept, though).
"Add in the article on immediate annuities, which are a great aid in personal retirement planning. For those that think that immediate annuities reduce the inheritance to the children, I would simply say that it is longevity insurance. If the annuitant lives a long time, he might run out of assets, and might rely on his children for help. The immediate annuity would be there to kick in something."
Can't say I agree with this type of strategic planning at this point in time. Sure, people won't outlive their income, and people are living longer (even with the Swine Flu), but locking in a low rate with in today's interest rate environment makes no sense to me with current and future government spending, debt and deficits.
Add to this the future obligations of 10's of trillions of dollars for Medicare and Social Security, that relies on a dwindling tax base of fewer and fewer employees who work for fewer and fewer companies and we have a tsunami of trouble ahead.
But wait, there's more.....the unforseen issues of infrastructure failure, state and city failures, banking failures, Freddie and Fannie failures, pension guarantee association failures, natural disasters (they always come) and the list goes on....oh...and don't forget the need to keep U.S. imperialism alive and well!
Where will this funding come from?
Taxes or inflation (I'm not including default and don't believe any country in their right mind will loan the U.S. more money - China and Japan are doing what they can to get rid of what they have!).
Which will politicians choose to keep their job? (Think Mondale here)
How can an investment advisor consciously lock in their clients retirement with a guaranteed return that won't keep up with the coming inflation? Note: Yes, I know there are annuities that have an inflation hedge on a lower starting amount (taken from the clients principal), but just like TIPS, these new type of annuities won't keep up with real inflation - they are insurance companies right? Their bottom line is what's important. And how many of these insurance companies are in trouble with their separate account assets that are heavily invested in commercial real estate?
Bottom line: How can all of these issues be accounted for financially without inflation?
Whew....
Excuse me while I go back to my recorded episode of last night's TMZ as that's much more important to We the Serfs!
In addition I think that static asset allocations can be done much better than the mean/variance portfolios by avoiding two pitfalls of that approach:
1) Ignore correlation data from any rosy periods since it doesn't really matter.
2) Drop the "most return per unit risk" optimization plan because this pushes the portfolio into the asset classes with outstanding risk-adjusted returns. Assets always look great on a risk-return basis right before they mean revert!
For example, I was planning on retiring my mortgage with money from gains in the market. The I was sick with pnemonia for a couple of months. I did not complete the payoff prior to the stock market drop in the fall, and the money was still in equities, not in a less volatile investment.
The when of paying off my mortgage would have been an immediate 6 per cent return on what I used, versus a hypothetical future gain (and real world 50 percent loss), delaying my when on investment return risk to the far future.
So when becomes an important factor as well....
Modern Portfolio Theory has failed...Really?...And the response is a long laundry list of qualitative factors that amount to little more than market timing and sector/stock picking...Really?
MPT is based on the simple yet fundamenatl idea that asset classes move at diffrent speeds and directions...over a significant time horizon. The concept is applicable for anyone investoing for retirement or some other event +5 to 40 years distant. It is not applicable to traders. Compressing time horizons distorts the picture. So measuring returns of asset classes over the past 12 months is mostl likely going to give you a false result. It is like tossing "heads" once and beleiveing that you should never bet "tails" again.
The efficient frontier is the application of the simple and beautiful idea that two asset classes - risky and more risky can give you better returns than 100% of either. Adding in more asset classes makes this concept more interesting. The measure of risk is volatility of returns. You can argue about the measurement - but it is the right measure.
Creating a portfolio of assets that are truly diversified takes some skill. Sticking to it year in year out and rebalancing takes some nerve. Achieving returns that are above average over the long run takes some patience. All are in short supply.
If any of you are interested go to assetplay.net. It does a better job of explaining this stuff than I ever will.
That's all.
>
> I think that has more to do with taking advantage of unemployed cash
> strapped consumers
That is one factor. The fact that it is GOLD that they're trying to buy from those cash-strapped consumers, however, tells me something.
From my own experience, I think hedging during times when overall risk is perceived as extremely low would be more effective than asset allocation if properly done. Going into the downturn, my portfolio of fairly risky equities was hedged with $OEX Dec09 660 Puts, accumulated over time to hedge staqrting at 10% on the downsided. The cost was budgetted at 2% of my portfolio annually.
Regretfully I chose to liquidate the hedge in January 08, at a nice profit, but in retrospect it was a horrible bottom call. In any event, hedging very possibly would be more effective than allocation, the caveat being the hedge has to be inititiated when risk seems far away and everything is going good.
We can attempt to compare the EPS of a stock relative to its sector (based in part of sector rotation) as compared to the EPS of the S&P 500 in an attempt to determine if something is valued appropriately for the direction that you want to invest in. We can wonder about how the Governemtn allows companies (more specifically banks and insurance companies) to hide toxic assests. We can attempt to decipher or prognosticate where the market is and where it is going.
If you trade (and to some small degree, invest with insurance in place for your positions, whether it is married puts to long equities, married calls to short positions, or hedging, as in long one commodity, short its inverse), ultimately, each of us has to decide on our own what the sentiment of the market is what value different assest classes possess (or lack).
I prefer to KISS. fundamental analysis supported by technicals with an over bias based on market sentiment.
Good luck to all, I believe that we are in for a difficult couple of years to come as we (the entire world) will have to pay for the various "bail out" plans and "back stops" that have been implemented. There is money to be made in the markets but it will require nimble action and a willingness to accept what the market is telling us whether we agree or not.
As Warren Buffett said so eloquently, "Be fearful when others are greedy and greedy when others are fearful."
That just doesn't make sense, because conditions change and, well, markets are markets. Correlations between or among assets can change back and forth over time. That's why you can hit a period where essentially everything's a loser. And the more granular you make it (i.e., the more asset classes you define, including hedges on some or all of them), it seems that the more likely there are to be mistakes, not to mention frictional costs to keep the allocations in line.
My asset allocation approach addds flexibility. Just to keep it simple, let's say I just define three categories: stocks, bonds, and cash. Let's say I determine that an ideal allocation target for me, at my age, with my level of risk tolerance, and in "normal" times, is 50%-40%-10% respectively. Then add flexibility to that, say +/- 30% of each "target", which now becomes the midpoint of a range. My stocks target then becomes 35%-65%, and my bonds target becomes 28%-52%. My cash target I treat as a special case, because there may be times when I want a lot of my investable income in cash. So the cash target range becomes 10%-37% (the latter would be when I pulled money out of stocks and bonds to the maximum extent).
The flexibility of target ranges allows me, without breaking from my basic allocation principles, to move money around in response to changing conditions. I don't attempt to define, nor rely on, a rigid, "perfect" set of allocation targets that's going to work all of the time. I don't think that exists.