By showing declining equity exposure as a retirement date approaches, target date fund managers imply that portfolio risk is automatically being reduced. This seems like a wonderful thing to investors who do not have the time or inclination to make asset mix changes themselves. Well, 2008-2009 showed us that risk for each asset class is far more important than the static relationship that professional money managers use to establish diversification between asset classes. In other words, they buy stocks, bonds, cash, and commodities in the belief that they all won't zig at the same time.
Target date 1.0 offered a date in the future. Target date 2.0 added conservative, moderate and aggressive options to each target date but the flaw remains. Fixed equity glide paths are like staring at a balance sheet; useful in helping to describe a "point in time" but useless in a dynamic capital market with risk that changes...often by a lot!
Target date 3.0 uses a dynamic glide path and constant volatility re-balancing. This means that the RISK of the portfolio is managed to a declining glide path and the asset mix is changed to reflect what is happening in the market right now. In TDF 1.0 and 2.0, the asset mix is managed to a fixed glide path while the risk is allowed to fluctuate. It doesn't make any sense to subject an investor to inappropriate risk. Furthermore, investors working towards a capital accumulation goal should know whether they are ahead or behind their projected growth path. TDF 3.0 automatically shifts risk based on progress towards this goal. Get behind, take a little more risk, get ahead, take a little less. Common sense. How does one do this for a defined contribution pension plan with thousands of members? Mass customization. www.purinvesting.com
Showing posts with label asset allocation. Show all posts
Showing posts with label asset allocation. Show all posts
Monday, July 12, 2010
Thursday, May 20, 2010
The Death of Asset Allocation as You Know It Part 2
“Experienced investors understand four wonderfully powerful truths about investing, and wise investors govern their investing by adhering to these four great truths:
1. The dominant reality is that the most important decision is your long term mix of assets; how much in stocks, real estate, bonds, or cash.
2. The mix should be determined by the real purpose and time of use of money.
3. Diversify within each asset class – and between asset classes. Bad things do happen – usually as surprises.
4. Be patient and persistent. Good things come in spurts – usually when least expected – and fidgety investors fare badly. “Plan your play and play your plan,” say the great coaches. “Stay the course” is also wise. So is setting the right course – which takes you back to great truth number 1.”
— Charles D. Ellis, 2007
Charles Ellis is a dean of institutional investing. The founder and managing partner for 30 years of respected consulting firm Greenwich Associates, he pioneered the systematic application of measurable investing activity. Supported by the 1986 research of Gary Brinson, L. Randolph Hood, and Gilbert Beebower, and follow on work by Jahnke, Ibbotson and others, the important role of asset allocation in the investment process developed.
In 2008-2009, extreme volatility, caused by the financial crisis, repealed the laws of asset allocation. Everything went down. Judicious choice of non-correlated assets was meant to invoke the protective properties of diversification. But correlations, based on historical relationship, have always wavered in the face of crisis. Yet advisors and professional investors alike embrace the tenets articulated by Ellis above.
It is not that these platitudes are wrong. There aren’t many absolutes in the investment world after all (except, perhaps, that costs detract from returns). Rather, there should be a fifth truth:
“The risk of assets selected for a portfolio should not only be consistent with the goals, time horizon, and risk tolerance of the investor or mandate, but should be kept consistent particularly when market risk rises and falls.”
Risk is like the temperature of bath water, some like it hotter than others, some cooler. If the temperature is too hot, add some cool. Conversely for a cooler bath, remove some cool and add some hot. Portfolios can be managed the same way.
If you would like to follow our ongoing research, please leave your email address and we’ll keep you apprised as we progress over the next several quarters.
1. The dominant reality is that the most important decision is your long term mix of assets; how much in stocks, real estate, bonds, or cash.
2. The mix should be determined by the real purpose and time of use of money.
3. Diversify within each asset class – and between asset classes. Bad things do happen – usually as surprises.
4. Be patient and persistent. Good things come in spurts – usually when least expected – and fidgety investors fare badly. “Plan your play and play your plan,” say the great coaches. “Stay the course” is also wise. So is setting the right course – which takes you back to great truth number 1.”
— Charles D. Ellis, 2007
Charles Ellis is a dean of institutional investing. The founder and managing partner for 30 years of respected consulting firm Greenwich Associates, he pioneered the systematic application of measurable investing activity. Supported by the 1986 research of Gary Brinson, L. Randolph Hood, and Gilbert Beebower, and follow on work by Jahnke, Ibbotson and others, the important role of asset allocation in the investment process developed.
In 2008-2009, extreme volatility, caused by the financial crisis, repealed the laws of asset allocation. Everything went down. Judicious choice of non-correlated assets was meant to invoke the protective properties of diversification. But correlations, based on historical relationship, have always wavered in the face of crisis. Yet advisors and professional investors alike embrace the tenets articulated by Ellis above.
It is not that these platitudes are wrong. There aren’t many absolutes in the investment world after all (except, perhaps, that costs detract from returns). Rather, there should be a fifth truth:
“The risk of assets selected for a portfolio should not only be consistent with the goals, time horizon, and risk tolerance of the investor or mandate, but should be kept consistent particularly when market risk rises and falls.”
Risk is like the temperature of bath water, some like it hotter than others, some cooler. If the temperature is too hot, add some cool. Conversely for a cooler bath, remove some cool and add some hot. Portfolios can be managed the same way.
If you would like to follow our ongoing research, please leave your email address and we’ll keep you apprised as we progress over the next several quarters.
Thursday, July 2, 2009
Goals-based asset allocation: Part A
There is not much new in the world of asset allocation despite the drubbing portfolios sustained last year. The best and the brightest minds and the most researched and supported techniques failed to save Humpty Dumpty from shattering on impact as he fell from that wall.
The Harvard and Yale Endowments, and in Canada, the Ontario Teachers' Pension Plan and le Caisse de depot et placements with extensive risk budgeting tools and an enviable record of success, succumbed to the same gap in the system that eliminated 30-40% of the value of stock portfolios globally. Capital markets went into "rectal lock" and values plummeted in the ensuing vacuum.
What were the goals of these institutions? Did they achieve what they set out to achieve? What could have been done differently? All these questions are being asked and the industry, its observers and consultants have been offering opinions. The "finger pointing" has been extraordinary. The only question that is meaningful for most of us is: what can investors and investment professionals learn from this experience?
Asset allocation describes the strategy investors follow to divide their money between different assets like stocks, bonds and cash. The underlying principle is that the prices of different assets move in different (uncorrelated) ways leading to the idea that "diversification" protects against risk, as defined as volatility.
The obvious problem is that this approach says little about the objectives of the investor. Volatility is an abstract concept for most retail investors. After the extreme volatility of capital markets last year, I suspect it is a more distant concept for many professionals also.
Goals-based asset allocation attempts to match the volatility of a group of assets to the broad goals of an investor. I'll explore how to do this in future posts.
The Harvard and Yale Endowments, and in Canada, the Ontario Teachers' Pension Plan and le Caisse de depot et placements with extensive risk budgeting tools and an enviable record of success, succumbed to the same gap in the system that eliminated 30-40% of the value of stock portfolios globally. Capital markets went into "rectal lock" and values plummeted in the ensuing vacuum.
What were the goals of these institutions? Did they achieve what they set out to achieve? What could have been done differently? All these questions are being asked and the industry, its observers and consultants have been offering opinions. The "finger pointing" has been extraordinary. The only question that is meaningful for most of us is: what can investors and investment professionals learn from this experience?
Asset allocation describes the strategy investors follow to divide their money between different assets like stocks, bonds and cash. The underlying principle is that the prices of different assets move in different (uncorrelated) ways leading to the idea that "diversification" protects against risk, as defined as volatility.
The obvious problem is that this approach says little about the objectives of the investor. Volatility is an abstract concept for most retail investors. After the extreme volatility of capital markets last year, I suspect it is a more distant concept for many professionals also.
Goals-based asset allocation attempts to match the volatility of a group of assets to the broad goals of an investor. I'll explore how to do this in future posts.
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