Asset allocation predates modern portfolio theory. Its essential premise is that you reduce the risk of catastrophic loss by holding multiple asset types. This limitation of potential loss is what most clients value highly, not higher returns. Capital preservation is the principal focus of the moderately wealthy.
In contrast, the Modern Portfolio Theory version of asset allocation focuses on correlation and returns. While the textbooks usually manage to state correctly (in terms of the theory) that you can choose to have lower risk for the same return, what most practitioners seek to do is generate higher returns for the same risk.
Given the well-established fact that catastrophic events occur five to 10 times more frequently than MPT assumes, this can only have one result: the client takes on more risk than they wanted to.
A decade ago, when naïve advisers believed in the efficient frontier, they were happy to use strategic asset allocation as a basis for portfolios. Only the failures of the theory – notably, increasingly close correlations between asset classes and too-frequent catastrophic events – caused them to consider that such strategic asset allocation was not enough.
Hence the latest trend of tactical asset allocation. This term is now abused by some to mean very active switching between asset classes – often with the spurious justification that if you use passive investment vehicles such trading is cheap. This is speculation, not investment.
Ask how long the practitioners of such methods have been using them and reflect on Bob Dinda’s statement: “There are old traders around, there are bold traders around, but there are no old, bold traders around”.
While some traders will win over the short term, all will lose over the long term, unless you disbelieve the academic research that demonstrates that ‘market timing’ is the least viable form of investment strategy. It is the polar opposite of Warren Buffett’s approach.
That is not to say that entry and exit points are not important. The history shows that buying when an asset class is cheap or dear is by far the most important factor in the returns you earn. Taking this into account, a viable form of tactical asset allocation is to adopt a through-the-cycle long-term strategic asset allocation that you then tilt ‘tactically’ based on the relative cheapness and dearness of the asset classes. This changes relatively slowly and so do your tilts.
That, oddly enough, corresponds pretty closely to what old-fashioned investment managers were trying to do before Modern Portfolio Theory was invented.
I have yet to see any evidence that MPT methods have resulted in any improvement of results as far as the client is concerned, though undoubtedly revenues of fund managers and creators of financial products have grown substantially thanks to MPT.
To avoid being accused of being a Luddite, I must add that some MPT tools are useful in comparing securities within a market (and, to a lesser extent, funds). But their use in portfolio construction is fundamentally flawed since they are all statistically based and backward-looking
If, as some MPT practitioners do, you ‘correct’ or adjust certain factors in making projections, you might as well not use the box of tricks at all since you are substituting human judgment for what MPT says should be derived just from the numbers.
As Warren Buffett says, if you want to be a successful investor, forget the algebra.
Chris Gilchrist is director of FiveWays Financial Planning, edits the IRS Report newsletter and is the author of the Taxbriefs Guide, The Process of Financial Planning