What Asset Allocation Means to Me

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  • on March 6th, 2011

I’m glad to see some great coverage of asset allocation, as it is a concept offering so much to investors but under assault in recent years.  Personally, I accept its general goal as a diversified portfolio of investments with differing correlation streams, with one major difference.  I view with suspicion the belief that these cross-relationships are, by birthright, destined to act in future decades just as they have in past ones.  As Dr. Bryan Taylor pointed out in this paper(HT Meb Faber), one gets dramatically different results looking at returns pre-1950 than after…is it right for us to build a 20 year plan on data from the greatest wealth machine(post-World War 2 United States) in human history?

I say no, which is why I prefer a more tactical and dynamic approach to allocating money.  We can use strategies operating in different timeframes to achieve diversification.  We can combine different styles to achieve low correlation.  And we can choose different asset classes but use a responsive filter like trend following in case the next 20 years doesn’t look like the last 20.

In any case, our belief in asset allocation does not have to be a “Yes” or “No” answer; there are shades of gray that any operator should contemplate before implementing a strategy.  Following are a few questions one should ask:

1) Do I believe that this sample of data represents an indisputable truth?

2) Have I chosen a lookback period that matches my potential holding period?

3) Are the reasons for past correlations inherent or a fluke?

4) When future reality fails to match my expectations, how will I react?

I personally believe that human tendencies will persist, far more than I believe historical return patterns will persist.  People will get scared of losing, they will get scared of missing out, they will react too slowly to new news and too quickly to old news.  Those, to me, are black and white issues of truth.  Will we have another World War? If so, will the result be more or less prosperity?  Will there be enough resources to support a growing human race?  Will global trade continue to spread wealth?  Talk about gray areas!

Rather than feel forced to choose a path of giving up(sitting in CDs) or giving in(buying and holding), I’ve made a years long effort to be a disciplined observer of these human tendencies and develop strategies in line with how human beings have and will continue to act.  The work of Meb Faber brought Tactical Asset Allocation to the masses.  The work of Ed Easterling shows how we can use valuation and cycles to position for maximum reward per unit of risk.  The work of Ray Dalio shows how we can use the historical returns of various asset classes but remain open to shifting patterns.

This line from Harry Markowitz is indisputable…”to reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other”.  Duh.  But while the return patterns of asset classes such as bonds and stocks usually differ, they don’t always differ in the same way.  And if our need to use our money happens at the wrong spot on the calendar, the potential for emotional decisions could result in drastic action at the exact wrong time.  Attributes like flexibility and imagination seem to be a better fit for dealing with the markets than academic theory and/or a reliance on predictive ability.

Rather than plug and play and assume a strategy will protect them, it’s my belief that diversifying by timeframe and style and asset class offers the most robust protection against the two things everyone worries about…losing money, or outliving our reserves.   Modern portfolio theory is an improvement on buy and hold.  Tactical asset allocation is a improvement on modern portfolio theory.  Ask yourself if, in the next 20 years, we are more likely to see a)market returns repeat the past or b)investor behavior repeat the past.

To bet on the latter, as I do, requires not a crystal ball but an acknowledgement that we don’t know squat about the future.  Respect for change and protection from worst-case outcomes are far safer ways to invest than a belief that “rational” actors will produce the same(or even similar) set of results as they have in the past.  Call me crazy, but I choose to make ultra-conservative assumptions regarding correlation and expected returns.  My job from there is to supplement that conservatism with a diverse set of long and short-term return streams to take advantage of the inevitable misreactions by the market’s irrational majority.  The safest bet of all is that they will continue to happen.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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