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In 2008-2009, extreme volatility, caused by the financial crisis, repealed the laws of asset allocation.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.

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