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For prudent investors, asset allocation serves as the cornerstone of a sound investment strategy. A sensible investment policy should consider factors such as investment time horizon, goals, future plans to save, potential for emergency expenditures, cash flow projections, and psychological tolerance for losses. These factors should be balanced with economic and market expectations to construct an appropriate mix between high-risk and low-risk assets. A portfolio with a larger allocation to high-risk assets should offer the potential for greater returns. On the other hand, a portfolio with more exposure to safer, low-risk investments should be expected to deliver stability and more modest returns.
Sounds easy enough… Unfortunately, this simple, effective concept has become lost on too many investors in favor of overly-complicated strategies that lead to performance-chasing, higher fees and, hence, lower returns.
“Wealth managers” have developed complex strategic asset allocation models in recent years and many have based these recommendations on a dangerous concept in investing: past performance. You have undoubtedly read the standard investment disclosure that past performance is not indicative of future results. However, this adage is too often forgotten.
Take the recent survey released by Capgemini-Merrill Lynch and published in Barron’s on September 21st (see PDF attachment). The study compares the typical asset allocation strategy employed by wealthy investors in 2005, before the credit crisis and the “Great Recession,” with today, as our economy and credit markets appear to be recovering. Compared with 2005, the survey participants are now allocating less money to equities, real estate and alternative investments – the asset classes that have declined most through the crisis. To the contrary, the surveyed investors are parking more funds in cash and fixed income, which are the asset classes that have outperformed through the “Great Recession.”
Morningstar, Inc. recently reported that “bond funds attracted net deposits of $209.1 billion in the first eight months of the year while stock funds drew $15.2 billion.” They went on to state that “nine of this year’s 10 best-selling funds buy bonds and only one, Vanguard Total Stock Market Index Fund, focuses on equities.” These statistics represent further evidence that the vast majority of retail investors are showing a preference for fixed income. Regular readers of our commentaries know that the overwhelming response of individual investors is not normally a bullish sign.
The increase in fixed income from 21% to 30% in the Capgemini study is suspect when you consider the super-cycle bull market in bonds over the last 28 years. Bond prices move inversely to interest rates, so as rates have cratered, bond prices have boomed. Former Federal Reserve Chairman Paul Volcker boosted the federal funds rate to 20% in June of 1981 in order to break the back of inflation. Nearly three decades later, Federal Reserve Chairman Ben Bernanke has lowered the federal funds rate to 0%. The United States has experienced a steady decline in rates over nearly three decades.
Are the Capgemini results simply the consequence of investors neglecting to rebalance their portfolios? (Rebalancing would serve to increase exposure to “riskier” securities following big losses). Possibly, but the majority of “wealthy” investors receive professional advice, so either they have lost faith in the recommendations of their advisors, or the advisors themselves are basing their recommendations on past performance.
In recent years, wealth management firms have popularized the concept of “strategic asset allocation.” According to Investopedia, strategic asset allocation is defined as “a portfolio strategy that involves periodically rebalancing the portfolio in order to maintain a long-term goal for asset allocation.” On its surface, this is a great concept because it leads investors to buy low and sell high; the ultimate goal of investing. But, as the above-mentioned survey suggests, advisors may not be adhering to this strategy. So, when the concept would have been most potent, many have abandoned it.
In our experience, managers employing “strategic asset allocation” have increasingly followed a trend toward more asset classes and broader diversification. For instance, examine the model portfolio currently being recommended by Mohamed El-Erian, the well-known co-chief investment officer for Pimco (see PDF attachment). Mr. El-Erian is suggesting that investors commit funds to ten different asset classes, ranging from U.S. equities (simple enough) to special opportunities (your guess is as good as ours).
For the average individual investor, we see major problems with this approach. First, under most managers this portfolio would be very expensive. Investors would typically pay various fund managers to run each of the ten asset classes, and an additional fee for a financial advisor to “coordinate” the strategic asset allocation. Second, there is rarely communication among the ten fund managers, which dilutes the overall strategy. Third, the portfolio would ultimately contain a massive number of securities, making it extremely difficult to outpace market returns.
Although Mohamed El-Erian caters his recommendations to large, institutional investors, in reality, many individual investors apply a virtually identical strategy by building a portfolio of multiple mutual funds that invest in various asset classes. This strategy merely offers investors the “special opportunity” to pay exorbitant fees for broad diversification, an approach that is much more likely to enrich an advisor than his or her clients.
We do not view broad diversification among a never-ending list of securities as an effective means of managing risk. Rather, our Investment Philosophy Statement, which is available at www.atwatermalick.com/investment-approach.asp, outlines our straightforward, transparent approach to managing risk through asset allocation.
We believe the most significant risk-reward decision in investing is the allocation to stocks versus bonds and that this simple determination overwhelmingly dictates portfolio volatility. We do not invest our clients in stocks unless we conclude that an allocation to stocks is appropriate, given each client’s risk tolerance and time horizon. Our discussions of risk tolerance include both (1) financial ability to absorb short-term investment losses and (2) psychological ability to handle market fluctuations. For client assets that are not suitable for the stock market, we invest in individual fixed income securities for safety of principal and a steady source of income.
Today’s world of investing can be daunting. Investors must navigate a sea of investment options running the gamut from stocks and bonds to structured notes and credit default swaps. But, when it comes to investing, complicated is not necessarily more effective. As Leonardo da Vinci once said, “Simplicity is the ultimate sophistication.”
Our investment approach is straightforward, transparent, low-cost, tax-efficient and independent. We invite you to work with us.