The economy is far from healthy. Money market funds broke the buck. Lehman Brothers and Bear Stearns have disappeared. The government is bailing out AIG, banks, and car companies. It is no wonder the past two years have caused many to question their fundamental beliefs about the economy, our government, and about investing.
Nowhere has this been more evident than in the world of investing. The 50-plus percentage drop in various markets, including U.S. stocks, foreign stocks, real estate, and commodities, has caused many to question and even consider discarding the investment paradigm built over the last 50 years by Nobel prize winning economists. These are core portfolio construction beliefs, such as modern portfolio theory, often synonymous with asset allocation, diversification, or “buy and hold investing”.
Traditional financial planning, which uses asset allocation for investing, looks at factors like the investor’s age, his or her risk tolerance, and where the individual stands as far as achieving financial goals. From these factors, an asset allocation - the percentage of a portfolio allocated to stocks, bonds, real estate, commodities, and so forth - is determined. Once determined, it is only changed when the investor’s circumstances, such as advancing life stage or receiving an inheritance, move him or her substantially closer to fully achieving financial goals.
Asset Allocation Alternatives
In 1947, in a speech before the British House of Commons, Winston Churchill said, “Many forms of government have been tried and will be tried in this world of sin and woe. No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of government except for all those other forms that have been tried from time to time.”
The authors believe that modern portfolio theory, asset allocation, and traditional forms of investment planning are like democracy. They are far from perfect or “all-wise”, but they are the best systems we have for approaching sound investment principles.
So saying, the question remains, what are an investor’s alternatives to traditional asset allocation?
Many believe that timing the market is possible; in other words, it is possible to create a strategy for getting in and out of the market at the right time to capture gains and avoid losses. However, the authors have never found a single example of legendary investors who got rich by becoming masters of “timing the market”. In fact, solid research by Terrence Odean in the 1990s shows that those who traded more earned a lower return. His conclusion was, “Over-confidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.” Also, legendary fund manager Peter Lynch famously said, “Far more money has been lost by investors preparing for corrections or anticipating corrections than has been lost in the corrections themselves.”
Absolute Return Strategies
Often referred to as alternative investments, absolute return strategies include hedge funds, private equity, timber, and other investments. They are investments that aim to earn a significant return in all years and are not dependent upon the up or down of the market. These types of investments have become increasingly popular, especially with college endowments and pension funds. But as readers likely know, the endowments of colleges like Harvard and Yale declined by 20% to 30% in 2008. Now, that is hardly an absolute positive return.
Tactical allocation is, to a degree, a variant of market timing. It starts with asset allocation, but then adjusts the allocation percentages to various assets based on an assessment of whether those assets are over- or undervalued. Think commercial real estate is overvalued? Then decrease allocations from the original 10% to 5%. Perhaps this looks like a good time to invest in gold. Move that original 5% allocation to a 10% allocation. Think stocks are overvalued? Move from 70% stocks and 30% bonds to 60% stocks and 40% bonds. The problem is that it takes market timing to determine which assets are over- or undervalued and when to make changes.
Why Has Asset Allocation Failed?
Investors have concluded that asset allocation failed because they lost more than they expected to or were comfortable with. However, this is not a reason to abandon well-constructed diversified portfolios. The authors believe that some adjustments to the way traditional asset allocation is implemented will take place, therefore paying more attention to valuation. But a wholesale rush to get rid of investment theory that has been built over the last half century because it doesn’t always function as well as we would like is a mistake.
To paraphrase Churchill, asset allocation is the worst investment strategy except for all those other forms that have been pushed to the fore in the wake of the market’s recent decline.
These are the views of Sterling Retirement Resources and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult with your financial professional for more information. www.sterlingretirement.com
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*Steven C Finkelstein, CFP and Joel Greenwald, M.D., CFP are principals of Sterling Retirement Resources, Inc. St. Louis Park, Minnesota.