by Andy Hyer
Mean-variance optimization, fathered by Harry Markowitz in 1952, is still a widely used approach to asset allocation today despite the fact that the underlying assumptions of the theory have some serious flaws. This approach to asset allocation is derived by using statistical methods to estimate expected returns, volatilities, and covariances. All of this information gets plugged into a piece of software called an optimizer. The optimizer then sifts through every possible combination of assets and produces a graph showing a curve called an efficient frontier. Ranged along it are a series of optimal portfolios, from the lowest risk and return to the highest.
This is an elegant theory, but the theory can only approach reality if the inputs (expected returns, volatilities, and covariances) are accurate going forward. One approach to come up with those inputs is to forecast them, but forecasts, even expert forecasts, are notoriously inaccurate. A second way to come up with those inputs is to just use the long-term averages. An examination of the chart below [click to enlarge] should illustrate why the latter approach is fraught with danger.
Source: Rex Macey, Investments & Wealth Monitor, March/April 2012 Issue.
This chart demonstrates that historical relationships can change. The five-year correlation between domestic large stocks (Russell 1000) and the MSCI EAFE index varied but never exceeded 0.6 from the start of the dataset until the late 1990s. Consultants used this data to argue for international diversification. Who would have expected based on historical data that the correlation would rise to the 0.9 level matching the correlation of large U.S. stocks with small U.S. stocks? I suspect those relying on international diversification were quite disappointed.
Rather than relying on an approach to asset allocation that makes enormous assumptions about how the future should look, why not embrace a tactical approach to asset allocation that is designed to adapt? Correlations can change, variances can change, and returns can change and tactical asset allocation still has the potential to produce excellent returns over time.