Asset Allocation: Seeing the Forest for the Trees

by: James Picerno

Jason Zweig, one of the best financial journalists in the business, asks in his latest Wall Street Journal column : Can you make the risk of stocks go away just by owning them long enough?

This is a popular question and one that has been the focus of entire books, such as Jeremy Siegel's Stocks for the Long Run. It's also a useful question, but it's important to recognize that it's only one question for strategic-minded investors.

The reason, as Bob Litterman explained in Modern Investment Management, can be condensed to a single sentence: "The simplest and most practical insight from modern portfolio theory is that investors should avoid concentrated risk."

As fundamental truisms in portfolio theory and practice go, this one's at the top of the list for most investors. It's also among the most neglected rules in money management. Sure, most investors own some form of diversified funds. But too many people define their investment options narrowly, which can lead to trouble.

Consider again the topic of whether it's prudent to own stocks for the long run. In fact, that's a poor way to analyze the investment challenge. Instead, investors should begin by asking: Should I own the market portfolio?

A practical definition of the market portfolio is all the world's stocks, bonds, REITs and commodities, weighted by their respective market values. In theory, this is the optimal portfolio for the average investor with an infinite time horizon. The question is how we should change the asset allocation of the market portfolio to match our risk tolerance, expectations and financial situation? In addition, we must decide how (or if) to manage the asset allocation through time. Should we own all the asset classes? If not, why not? Should we employ a mechanical rebalancing system that reinstalls the previous asset allocation? Or should we use a form of tactical asset allocation premised on predicting risk premiums? How about a bit of both?

Such questions constitute the lion's share of relevant subjects for analysis in money management. Curiously, strategic analysis of this sort is rare. To be sure, using the market portfolio as a benchmark is no short cut to easy success. You still have to keep a close eye on the markets and make decisions about the future. But as a starting point, the market portfolio is a robust beginning. All the more so these days since index mutual funds, ETFs and other products allow us to build a reasonable proxy for the market portfolio.

The default strategy is owning everything in a passive asset allocation and letting it ride. How has this choice fared over the past 10 years? As you might expect, the results are middling. For the decade through the end of last month, the Global Market Index's annualized total return is 4.5%. By comparison, the best asset class performance is emerging market bonds, advancing by an annualized 12% over those years. The bottom performer is U.S. stocks, rising by roughly 0.7%, based on the Russell 3000.

We can spend all of our time debating if stocks are worthy of buy-and-hold investing for the long run. But if we do, we're missing the financial forest for the trees.