Rod Cole

Portfolio Building With Forward Looking Asset Allocation

Yes, it does sound like we are on the same page. Thanks for the clarification.

Rod

Portfolio Building With Forward Looking Asset Allocation

I have to wonder if the only thing worse than looking in a clear rear view mirror to form an asset allocation is to look through a fuzzy cracked windshield.

Clearly looking at a mere three years of data, as you do in your example above will tell you nothing useful about an asset allocation plan, but in many cases assets have a much longer history. There is little to support the notion that anyone can predict the future, even statistically, with any better accuracy.

As noted, blindly using any optimizer on noisy data (a short time history or predictions) runs the very serious risk of over fitting the data: fitting not only signal (real information), but also fitting noise. This is true regardless of whether or not one is using a short history or a prediction of where the markets are headed in the future. Indeed, even with a long history one has to worry about whether or not our future will look the same.

Perhaps the best way out of this mess of uncertainty is to use the heuristic, or something like it, you dismiss above. If looking back 10 years gives one allocation as best, looking back 20 years gives another, and looking forward gives a third, we know for certain all are most likely wrong in the fine scale, but perhaps right in the broad scale. Each is likely to tell us something like: buy a bunch of large cap, small cap, value, blend, domestic, international, and bonds, but it is silly to make overly fine distinctions about the exact percentage of each as each time we look we get a somewhat different answer. If you do anything other than pick some nice round numbers for each, you are fooling yourself with false precision.

Rod