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Linda P. Jones is America's Wealth Mentor. She is CEO of Be Wealthy & Smart, a business dedicated to teaching high income earners how to create high net worth by being prepared for the coming U.S. dollar devaluation, a result of the trillions of dollars being printed by the government. Linda... More
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  • 6 Reasons Why Today's Asset Allocation Models Are Broken 0 comments
    Apr 23, 2010 12:54 PM
    When considering possible future economic cycles and how asset allocation models are structured, asset allocation models today are not properly anticipating future economic trends, and may even be harmful to an investor’s financial well-being. 

    The father of asset allocation was Harry Markowitz, for which he earned a 1990 Nobel Prize in Economics. Far be it for me to criticise his celebrated work, but there are several points that don’t make sense with traditional asset allocation models. Asset allocation strives to maximize the expected return in an investor’s portfolio for a given level of risk, and to reduce the correlation of all securities moving together at the same time. 

    It is not merely which securities to own but how to divide the investor’s wealth among securities. Asset allocation models focus on three asset classes: stocks, bonds, and cash. They further distribute a percentage in small, mid, and large cap US stocks; emerging markets and international stocks; short- term, long-term, and international bonds; real estate (REITs); and cash. 

    There are usually about five standardised asset allocation models with fairly typical ratios of stocks, bonds, and cash as we have illustrated here: 

    In the stock and bond portion, the greatest percentage is usually allocated to US stocks and bonds, with a much smaller portion allocated to international or emerging markets. In the equity category, typically an amount less than 10 is allocated to real estate. So what we have are predominately U.S. oriented portfolios, and the more conservative one is, the more heavily one is weighted toward US fixed income. 

    Here’s why I see six reasons investors will likely have problems with traditional models in the future, especially the most conservative asset allocation strategies.

    The Six Problems with Traditional Asset Allocation Models

    1. A large allocation to bonds is not preferable given the interest rate cycle. Since 1982, interest rates have been declining from a high point around 18 per cent to nearly 0 per cent, which has increased bond valuations. Since interest rates today are at a low point, bonds cannot have large gains from here and are almost guaranteed to have losses, and potentially large ones if rates rise a lot over time. 

    Since most cycles last 15 to 30 years, anyone owning bonds will likely see principal allocated to bonds decline due to rising interest rates--the absolute worst thing for a conservative investor’s portfolio. The devastation is worse in bond mutual funds than it is with individual bonds. In bond mutual funds there are fees, and often the Net Asset Value erodes over time as interest rates rise. Individual bonds can be held to maturity and thereby avoid the interest rate risk. 

    But even avoiding the interest rate risk doesn’t mean they are avoiding the risk of loss due to inflation. The loss of purchasing power to all financial instruments such as CD’s, bonds, and annuities will eventually be felt when inflation inevitably returns in the next cycle, but I’m getting ahead of myself. 

    2. The second problem is what I call “investing in the rear-view mirror.” It means that one of the mistakes investors make is investing by looking at returns in the past and not from expected returns in the future. Stocks and bonds have performed well since the beginning of the bull market in August, 1982, but how will they perform in the next 30 years? Financials and commodities typically trade cycles every 15 to 25 years. 

    We’ve just finished a 25 year period (1982-2007) where financials have outperformed commodities. It’s likely we are heading back in the other direction and stocks and bonds will significantly underperform commodities.

    3. Asset allocation models are biased toward assuming low inflation. Inflation is likely to rear it’s ugly head again in the future because of all the money printing worldwide. Although some experts argue that stocks are a good inflation hedge, there are much better performing inflation hedges than stocks, traditional ones being commodities and precious metals. Real estate can be an inflation hedge, but because it is correcting from the bubble in the 2000’s and is in oversupply, it likely won’t be the inflation hedge it was in the 1970’s. 

    4. Commodities and precious metals are not even a part of today’s asset allocation models, so possibly the best future performing sectors are not even represented, except for the few present in stock indexes. Arguably, commodities and precious metals deserve a sizable portion in asset allocation models. 

    5. Real estate hasn’t bottomed. Although short-term indicators may show a bottom in real estate prices, it may just be that: short-term. No asset class declines in a straight line. The supply of real estate is high from the building spurt of the last decade, and once interest rates begin to rise, real estate prices will likely fall because people will have to pay more for the interest on their mortgage, and less for the house. 

    6. Demographics in the US have aged considerably. The age a consumer spends the maximum per year is age 46, according to demographer Harry Dent. After that, spending declines. More growth may come from the demographically advantaged countries, which means more should be allocated to international stocks and bonds instead of having a US bias. International and emerging market countries like China, Russia, Brazil, Korea, India, and Singapore have more favorable demographics and hence, more potential growth than the US.

    So while Markowitz had asset allocation right for his time, I believe there is significant worldwide change underway that would change the structure of asset allocation models when looking toward the future. 

    To truly understand the proper asset allocation for the future, we need to look forward to interest rate cycles, economic cycles, and investment cycles, which is the subject of my next column.

    As published in Alrroya newspaper.

    Disclosure: no positions mentioned
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