Why I'm Skeptical About Asset Allocation

I appeared last Friday on a the PBS program WealthTrack, where the topic was asset allocation, in particular, as host Consuelo Mack put it, how to build an all weather portfolio. I was the skeptic of the group. I don’t think there is some magic asset allocation that protects you from the buffetings of financial storms without it also trimming your sails during fair weather. Here is an encapsulation of my views from the program.

Asset allocation and risk appetite
One of the participants, asset allocation guru David Darst of Morgan Stanley (MS), proposed various portfolios to protect against a 100-year flood, 30 to 70-year flood, a 25-year flood, etc. Those portfolios boiled down to putting less in risky assets and more in bonds; the more severe the flood you anticipate, the less risk you take. Of course, that will do the trick. If by asset allocation you mean determining where to set your risk tolerance dial, we’re all on board.

Asset allocation is like clapping with one hand
But the discussion of risk tolerance highlights that we can only go so far with asset allocation if we only look at assets. What matters is assets versus liabilities, because the liabilities determine our risk tolerance and, related to that, our demand for liquidity. It is impossible to formulate an ideal asset allocation strategy without knowing the liability stream those assets are intended to meet. There is no one-size-fits-all for asset allocation. This reminds me of an FAJ article I did back in the 1980s with pension actuary Jeremy Gold entitled “In Search of the Liability Asset”.

Diversification works well, except when it really matters
We all know the argument from Finance 101: If you hold 16 uncorrelated assets, your risk will drop by a factor of four. Well good luck with that.

During a crisis, when diversification really matters, correlations aren't near zero (as if they ever are). All that people care about is risk and liquidity. All assets that are highly risky drop, all assets that are less liquid drop. No one cares about the subtlety of earnings streams. It is like high energy physics. When the heat gets turned up high enough, matter is just matter, the distinctions between the elements is blurred away.

This is not to say that one should not try to diversify, but rather that one should not think diversification will work magic. It is a given that a portfolio should not be limited to U.S. Treasuries and S&P 500 stocks, because while it should not be oversold, diversification does have some benefit. And, on the other side, unless someone is still living in the 1970’s, it borders on the intellectually dishonest to trumpet a diversified portfolio by using the S&P 500 as the bogey. A college kid can construct a portfolio that will beat the S&P 500 on a risk-adjusted basis, because there are so many more markets available now. A better approach is to look at a given asset allocation versus its nearby well-diversified neighbors, and try to understand why one is better than the other.

Commodities do not form an asset class
This sounds heretical given what we have seen oil and gold do recently, but a lot of the reason that has happened is precisely because people are treating them as an asset class when they are not.

Commodities are not assets. They are factors of production. They do not generate returns, they have no claim on production. They have supply that flows out at a nearly fixed rate short term, and they comprise very small markets compared to the financial markets. If pension funds all decided to put two percent of their capital into commodities, two things would happen. First, that two percent would be a rounding error in their returns, no matter how commodities behaved. Second, they would swamp the supply of the commodities for economic purposes – i.e. for their true role as factors of production. I agree with Michael Masters’ view that oil prices were pushed up by this sort of financial activity. I might quibble with one chart or another, I might not couch it in the loaded terms of speculation. But the subsequent behavior of the market demonstrated that he was right and Goldman and others who took the opposing view were wrong.

Inflation-Linked Bonds
Which brings me to inflation-linked bonds. At the close of the program we all were asked for one investment recommendation. In one form or another we all focused on the same one: inflation-linked bonds. But I would not carve them out as a distinct asset class any more than I would commodities -- though unlike commodities, at least I think they are an asset. They are one of many assets that load on the inflation factor. If you have a long-term view, equities are also decent inflation hedge. After all, over time prices adjust, and so do earnings. And, as with commodities, the supply of inflation-linked bonds is low; there is a liquidity premium to pay.

I think what has elevated inflation-linked bonds from the category of “asset” to that of “asset class” is memories of the 1970s, a heyday for inflation-linked bonds. If you could have held them during the stagflation period, you would have looked golden; they would have given you a Sharpe Ratio of over 1.0 while many other assets was flat-lining. If I were building a simulation to beat the market on an historical basis, I would add in inflation linked bonds just for the pop they would give in that decade.

Comments

[bluesmoke:]

I'm no expert, and maybe that weighs in my favor. The main problem I have with inflation-linked bonds, (and I am assuming you are talking about TIPS here), is the distorted yardstick by which the US government measures inflation. Several other factors like a falling dollar come into play as well. So although you may not consider commodities an asset class, energy stocks, MLP's, Royalty Trusts, and other securities that rise in value when the dollar falls, AND generate income, are a much more accurate reflection of the true state of the economy. Plus, many of these are based in foreign currencies. Besides, putting all or a majority of your assets in a dollar based portfolio is limiting diversification.

Sep 27 11:19 AM

[chap08:]

If you have any assets then, like it or not, you practice asset allocation. Like it or not, you'd better think about your objectives and your attitudes to risk. This is the valuable, common sense part of asset allocation.

What I don't believe in is all the CAPM related nonsense. It's just more discredited economic theory. Another thing I don't like is when people fail to question their assumptions and end up putting other people at risk. "Asset allocation guru" David Darst thinks about putting "less in risky assets and more in bonds". This is a non sequitur if ever I heard one. The volatility of historical returns won't tell you this, so I will - long term treasuries are currently one of the riskiest assets you can buy.

Sep 27 01:39 PM

[mna:]

Your article is absolutely correct. Asset allocation is something that the financial advisors made up to cover their butts when things went bad. In a crisis, everything goes down. Sectors that have nothing to do with each other all of a sudden had huge correlation. The only thing that kept value in March were sovereign bonds and precious metals.

Going forward though... I wouldn't put much emphasis on sovereign bonds to protect your portfolio. It's pretty obvious that the sovereign powers don't intend to protect the value of their bonds in a crisis, and some savvy people in the market have already figured this out.

Sep 27 02:30 PM

[Ichabod:]

Excellent observations, to question commodities being "assets." I'll think it over.

My experience in allocation: In the Spring of 2008, I began shifting allocations toward those suggested by Indexinvestor. com, because their mountains of cited academic studies and vast proprietary computer back-tests seemed to yield sensible projections. (Their allocations, which include commodities and timber, are dependent on one's time window and retirement currency.)

My wife argued that there could be no such thing as an "all-weather portfolio," and that their back-tests used hypothetical allocations based on only a few decades of data. Following my wife's advice, and reacting to financial news, I began trimming all assets during June-Sept last year, going mostly to cash. As a result, our portfolio suffered a loss of just 10% by year-end.

I am not bragging, merely passing along factual evidence that TIMING is quite important, and that CASH is the basic asset, the stuff used to keep score. Sometimes it pays to ignore asset managers' mantra to be a "long-term investor," a stance constantly urged on the gullible public as though staying fully invested (usually in stocks) is somehow a morally superior strategy than moving away from risk when common-sense indications warrant.

Sep 27 02:42 PM

[macro -N- i...:]

chap08: I used Darst's allocation model this year. If you use it correctly, as I did, and combined it with Ichabod's restatement of how important timing is you would have seen(as in watched) the market fall and had a great return over the summer. Cash is never king but it can be an upstart dictator that wins over the short term.

Sep 27 07:00 PM

[a. palmer jr.:]

I looked at the bank watchlist a few minutes ago and think that, as it's helpful, there are several banks on it that share the same names with banks in my area which are NOT in trouble. They need to add some to their bank names so that people will not panic about a bank in another part of the country.

Sep 28 08:50 AM

[David Van K...:]

All of us are "fully invested" if you acknowledge that all of your money is somewhere, and one of those somewheres may be cash. We are also all "long-term investors" in the sense that it's a lifelong activity. It's a perversion of the term, IMO, to equate it with long-term HOLDING PERIODS, which is something else entirely. And all investors practice "timing" to a greater or lesser extent, even if it's confined to annual rebalancing of a portfolio or deciding where to put new money.

My point in going through that semantic exercise is that each of those three terms is emotionally loaded, and as soon as you use one of the terms, people conjure up images and biases. Then it becomes hard to have an intelligent discussion.

Asset allocation has its good points, and we shouldn't throw out the baby with the bathwater by over-emphasizing its problems. Probably not one of us would choose to have all of our money in one place, so we all practice asset allocation. That said, the idea that there is any such thing as an all-weather portfolio is nuts. It is true that in a crisis, normally uncorrelated assets all drop--they become very correlated, very fast. That's because people are fleeing risk in whatever form they see it.

Whether commodities are an "asset class" or not just depends on how granular you want to get. How many angels can dance on the head of a pin? Are "stocks" a single asset class, or are there multiple asset classes of stocks (foreign, domestic, large-cap, nano-cap, dividend-paying, growth, value, etc.)? Again, it all depends on how granular you want to get.

The bottom line to me is (1) allocate asssets for "normal times" in a common-sense but not very granular way, and (2) practice timing to move things about when that makes sense. It saddens me to read about people who become frozen or inert when the stock market crashes as in 2007-2009, watching their 401(k)s evaporate as if they are powerless to do anything about it. It doesn't have to be that way.

Sep 28 10:16 AM

[Hmm?!:]

IMHO: The general problem is that Americans could historically be successful investing only within their borders. Recent events have made it clear, that is no longer the case for the forseeable future.

In general, I do not believe the public, the politicians, nor Wall Street are properly prepared for this new reality.

Sep 28 10:33 AM

[whisperonth...:]

Several years back, success was defined as having a bunch more when you cashed out than when you started. After the last two years, a lot of people feel they've been successful if their portfolios have come back within the -10% range.

Investing is risky anyway, and some of us are braver than others (or more stupid, depending on your viewpoint). I tend to pick a couple highly risky but hopeful stocks, a couple very boring but reliable stocks, and the rest are emotionally chosen, based on what I like on any given stock purchase expedition.

I must be successful, since I'm now within that -10% range. Since at one point I was down almost 40%, I think my way is working. For now. Who knows how I'll feel tomorrow?

Sep 28 11:10 AM

[_richard_:]

Annuities. Think life annuities, with inflation-adjusted payments. If you want to do duration matching of lifetime income, think annuities. There's more bank for the buck there than high returns will ever get you.

Sep 28 11:55 AM

[Buckoux:]

Quote the Raven: "Nothing more!"


On Sep 27 02:30 PM mna wrote:

> Asset allocation is something
> that the financial advisers made up to cover their butts when >things went bad.

Sep 28 12:04 PM

[TLassen:]

Excellent article and good points for discussion. I do agree with you that there are no perfect asset allocation method that will protect you in a severe downturn like the one we went through.
I do think however, the point of asset allocation is meant to diversify away the systemic risk by not just holding 1 or 2 asset classes. We can diversify as much as we want within a given asset class, the value of diversification comes from the covariance between the classes. I am old investor with more than 25 years actual investing experience, so bear with me for my ignorance, but in 'the old days' there were only 4 asset classes: stocks, bonds, cash and tangibles. No such thing as commodities being an asset class. Nowadays investors are confusing asset class categories with asset classes. Small cap/large cap/ value etc are only sub categories of the stock asset class. We used to say, "diversify between AND within the asset classes"

Sep 28 12:29 PM

[Jack Walker:]

Richard,

In our view, you are certainly right to point out that commodities are at not suitable assets for long-term investment.

Commodity markets were established for short-term price discovery not for long-term capital investment. Is there any wonder why futures contracts have a limited life span?

We understand the important liquidity function provided by speculators, but using the term “Investor” in the commodity markets is an oxymoron since the short-term commodity price discovery function is incongruous with long- term investing.

When long- term pension fund and endowment assets are allocated to commodity markets it shifts the demand curve upward to the right and if supply is constrained then the new equilibrium price point is higher than would be determined solely by the producers and uses of the commodity. The resulting distorted price signals send the wrong messages to both producers and users as they make enormous long-term capital allocation decisions. Surely, this would improve the efficiency of the capital markets.

Are we shifting the higher price level to society as a whole for the benefit of a smaller group of pension fund beneficiaries?

Perhaps some pension fund trustees should reevaluate their role in the process.

Without the commodity index participation of the pension funds, perhaps we could once again try to match long-term investment objectives with long-term capital requirements based on accurate commodity pricing data.

Will you continue to question the participation of pension funds in commodity indexes?

Jack

Sep 28 01:27 PM

[BlueOkie:]

AA starts with "don't put all your eggs in one basket" and that's good. After that it is a down hill ride. What percentage of each asset to you use and why? How often do you rebalance and why? AA looks in the rearview mirror for risk/reward. Only people making money on AA are those who get fees and commissions. When the economy crashes, then AA only response is I beat the S&P.

Sep 28 01:52 PM

[searcher:]

RE: Tangibles vs. Commodities. 'Commodity' is a loaded term implying contracts and their derivatives and/or materials (not concepts) ie. 'tangibles'. Tangibles are not liquid. To secure liquidity you must accept securitization. The term 'commodity' allows conflation through ambiguity.

Sep 28 02:25 PM

[Crashnburn:]

Yes, diversification works, except when you need it the most.
Yes, equities and fixed income investments fell in price during the financial armaggedon, but fixed income fell slower and less than equities.

This means that if you rebalanced as the equity/bond ratio got out of balance, you were still selling sort of high, and buying really low. Now that the market has risen significantly since the March 8 low, those who moved money from bonds to equities are better off than those who left thier investments alone.

I was mostly in cash from Sept to November, when I bought enough TIP shares to keep the reamaining cash in my accounts fully insured against loss. I made about 8% between the time I bought the bonds, and the time I sold the ones I sold (I still have TIP shares)

Instead of buying the actually commodities, I buy shares of the producers of those commodities. I get exposed to the stock market, and to the price of the commodities that way.

Sep 28 06:30 PM

[Old Trader:]

"After the last two years, a lot of people feel they've been successful if their portfolios have come back within the -10% range."

As I recall, the grim "humorous" line circulating in the hedge fund world last year was "Down 10% is the new flat".

Sep 28 07:57 PM

[TLassen:]

The Bond class did not 'fall in price during the financial Armageddon"

Fixed Income Mutual Funds and Bond funds sure did, because they do not really belong to the bond class, as they are traded as stocks. Bond funds and fixed income mutuals are excellent substitutes for 'real' bonds, but they come with the same risk as equities (16% std dev).

I believe investors have to remember that holding bonds to maturity in lieu of funds and bond ETF's involves much less risk. (mostly inflation and default risk) Therefore bonds offer a real diversification to the stock, cash and tangible asset classes

Unfortunately, at least 30 G is required to build a decent bond ladder for the bond class allocation


On Sep 28 06:30 PM Crashnburn wrote:

> Yes, diversification works, except when you need it the most.
> Yes, equities and fixed income investments fell in price during the
> financial armaggedon, but fixed income fell slower and less than
> equities.
>
> This means that if you rebalanced as the equity/bond ratio got out
> of balance, you were still selling sort of high, and buying really
> low. Now that the market has risen significantly since the March
> 8 low, those who moved money from bonds to equities are better off
> than those who left thier investments alone.
>
> I was mostly in cash from Sept to November, when I bought enough
> TIP shares to keep the reamaining cash in my accounts fully insured
> against loss. I made about 8% between the time I bought the bonds,
> and the time I sold the ones I sold (I still have TIP shares)
>
> Instead of buying the actually commodities, I buy shares of the producers
> of those commodities. I get exposed to the stock market, and to the
> price of the commodities that way.

Sep 28 08:00 PM

[E.D. Hart:]

So silver and oil are not assets? Why do we sell them then? Don't forget that cash is an asset too. When I trade my silver for cash I'm switching asset classes effectively in that particular transaction.

You are not taking a well thought out contrarian view, intellectual and nuanced, but rather a very mainstream view shared by casual investors.

Hedge funds, all the 40 or so that I follow, consider gold, oil silver, natural gas, etc....asset's that differ markedly from other assets, and therefore constitute a separate class.

There were problems with asset allocation this last year to be sure but most of your article is a long non sequitur. Some of your premises are incorrect, and your overall conclsion is non sequitur.

Correlation vary and break down, that doesn't mean that assett allocation doesnt work. Commodities as a class broke down last year and failed to provide the diversification benefit, but gold did not.

Treasuries did not fail either. If you consider treasuries and gold as separate assets, as I do, and you were hedging against both delfation and inflation you would have had 8 consecutive years of postive return including last year.

Tell me that doesn't work.

Sep 28 09:01 PM

[G. L. Turner:]

Oh well,
Here I am back here again.

"Agree with Mike Masters, as he was right and Gov. Sachs and kin were wrong..."
They weren't wrong...they were creating the pricing scenario/bubble that the shills were claiming were s/d fundamentals.
Who do you think was the first to short in June 2008, ahead of the other funds that crashed in the downdraft starting the next month.

Sep 28 11:21 PM

[Old Trader:]

TLassen,

You're 100% spot on in pointing out the big difference between holding bonds until maturity, and using funds of either open or closed types for the fixed income portion of a portfolio. Actually, I think you might be a bit optimistic in thinking that $30k is enough to construct a decent fixed income allocation. My guess would be closer to $100k.


On Sep 28 08:00 PM TLassen wrote:

> The Bond class did not 'fall in price during the financial Armageddon"
>
>
> Fixed Income Mutual Funds and Bond funds sure did, because they do
> not really belong to the bond class, as they are traded as stocks.
> Bond funds and fixed income mutuals are excellent substitutes for
> 'real' bonds, but they come with the same risk as equities (16% std
> dev).
>
> I believe investors have to remember that holding bonds to maturity
> in lieu of funds and bond ETF's involves much less risk. (mostly
> inflation and default risk) Therefore bonds offer a real diversification
> to the stock, cash and tangible asset classes
>
> Unfortunately, at least 30 G is required to build a decent bond ladder
> for the bond class allocation

Sep 29 01:44 AM