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ASSET ALLOCATION
BALANCING FINANCIAL RISK
By ROGER GIBSON, CHRISTOPHER J. SIDONI The McGraw-Hill Companies, Inc.
Copyright © 2013 McGraw-Hill Education LLC.
All rights reserved.
ISBN: 978-0-07-180419-6
Excerpt
CHAPTER 1
The Importance of Asset Allocation
Not only is there but one way of doing things rightly, there is but one way of seeing them, and that is seeing the whole of them.
—John Ruskin (1819–1900), The Two Paths, 1885
The capital markets have changed dramatically over the last few decades, and investment management has undergone a concurrent evolution. In the early 1960s, the term asset allocation did not exist. The traditional view of diversification was simply to "avoid putting all your eggs in one basket." The argument was that if all your money was placed in one investment, your range of possible outcomes was very wide—you might win very big, but you also had the possibility of losing very big. Alternatively, by spreading your money among a number of different investments, you increased the likelihood that you would not be either right or wrong on all of them at the same time. Narrowing the range of outcomes created an advantage.
For the individual investor, those were the days when broad diversification meant owning several dozen stocks and bonds along with some cash equivalents. For pension plans and other institutional portfolios, the same asset classes were often used in a balanced fund with a single manager. Because the U.S. stock and bond markets constituted the major portion of the world capital markets, most investors did not even consider international investing. Bonds traded within a fairly narrow price range. Security analysis concentrated more on common stocks, the common belief being that a full-time skilled professional should be able to consistently "beat the market." The money manager's job was to add value through successful market timing and/or superior security selection. The focus was much more on individual securities than on the total portfolio. The prudent man rule, with its emphasis on individual assets, reinforced this type of thinking in the fiduciary community.
As time passed, large swings in interest rates dramatically increased price volatility, and bonds moved out of their narrow trading ranges. Multiple managers on both the fixed-income and the equity portions of institutional portfolios replaced the single balanced manager. With institutional trading on the rise, the full-time professionals were no longer competing against amateurs. They were now competing against each other.
Imagine for a moment the floor of the New York Stock Exchange. Willing buyers and sellers are generating millions of transactions. For any single transaction, the buyer has concluded that the security is worth more than the money, while the seller has concluded that the money is worth more than the security. Both parties to the transaction may be institutions that have nearly instantaneous access to all publicly available relevant information concerning the value of the security. Each has very talented, well-educated investment analysts who have carefully evaluated this information and have interestingly reached opposite conclusions. At the moment of the trade, both parties are acting from a position of informed conviction, though time will prove one of them right and the other wrong. Through free market dynamics, the security's transaction price equates supply with demand and thereby clears the market. A free market price is therefore a consensus on a security's intrinsic value.
In the investment management business, the stakes are high and the rewards are correspondingly great for successful money managers who are able to produce a consistently superior return. It is no wonder that so many bright, talented people are drawn to the profession. In such a marketplace, however, it is difficult to imagine that the market price for any widely followed security will depart meaningfully from its true underlying value. This is the nature of an efficient market.
In both investment management and academic communities, considerable, ongoing controversy exists regarding the degree to which the capital markets are efficient. The debate has far-reaching implications. To the extent that a market is inefficient, opportunities exist for individuals to exercise superior skill to produce an above-average return. While various market anomalies do seem to indicate that the capital markets are not perfectly efficient, most research supports the notion that the markets are reasonably efficient. The accelerating advances in information processing technologies will undoubtedly drive the markets to become even more efficient in the future. It thus will become increasingly unlikely that anyone will be able to consistently beat the market.
The tremendous growth in the use of index funds serves as tangible evidence that this issue is not solely one of academic curiosity. In an efficient capital market, the expectation is that active management, with its associated transaction costs, will result in below-average performance over time. If this is true, one way to win the game is never to play it at all. Those who have invested in index funds have chosen not to play the security selection game. It is ironic (yet logical) that the same high-powered money management talent that creates the efficiency of the marketplace likewise makes the achievement of an above-average return so exceedingly difficult. Even in those situations where a money management organization has a unique proprietary insight that enables it to produce a superior result, the advantage will erode over time if other money management organizations discover and exploit the process.
In 1952, Harry M. Markowitz published an article entitled "Portfolio Selection." In this article, he developed the first mathematical model that specified the volatility reduction that occurs in a portfolio as a result of combining investments with different patterns of returns. The amazing thing about his accomplishment is that he developed his thesis over a half century ago, long before the advent of the modern computer. His influence on the world of modern finance and investment management has been so profound that he became known as the father of modern portfolio theory and was awarded the Nobel Prize in Economics in 1990.
Before modern portfolio theory, investment management was a two-dimensional process focused primarily on the volatility and return characteristics of individual securities. Markowitz's work resulted in the recognition of the importance of the interrelationships among asset classes and securities within portfolios. Modern portfolio theory added a third dimension to portfolio management that evaluates an investment's diversification effect on a portfolio. Diversification effect refers to the impact that the inclusion of a particular asset class or security will have on the volatility and return characteristics of the overall portfolio.
Modern portfolio theory thus shifted the focus of attention away from individual securities toward a consideration of the portfolio as a whole. The notion of diversification had to be simultaneously reconsidered. Optimal diversification goes beyond the idea of simply using a number of baskets in which to carry your eggs. It also places major emphasis on finding baskets that are distinctly different from one another. The differences are important because each basket's unique pattern of returns partially offsets the others, with the effect of smoothing overall portfolio volatility.
In an efficient capital market, security prices are always fair. Given this premise, modern portfolio theory stresses the wisdom of investing in a broad array of diverse investments. These concepts later received legislative endorsement in the Employee Retirement Income Security Act of 1974, which governs the management of corporate retirement plans. The act legislates the importance of diversification within a broad portfolio context. In 1992, the basic rule governing the investment of trust assets, known as the prudent investor rule, was restated to "focus on the trust's portfolio as a whole and the investment strategy on which it is based, rather than viewing a specific investment in isolation." Later, this thinking was incorporated into the Uniform Prudent Investor Act (1994), which governs fiduciary investing in most American states. John H. Langbein, the eminent legal historian and principal drafter for this legislation, wrote:
The emphasis on diversification also underlies another prominent feature of the Uniform Act, the portfolio standard of care in section 2(b), which reads: "A trustee's investment and management decisions respecting individual assets must be evaluated not in isolation but in the context of the trust portfolio as a whole ..." The official Comment says: "An investment that might be imprudent standing alone can become prudent if undertaken in sensible relation to other trust assets, or to other nontrust assets." This insistence on diversifying investments responds to one of the central findings of Modern Portfolio Theory (MPT), that there are huge and essentially costless gains to diversifying the portfolio thoroughly.
He went on to comment:
The other great lesson from MPT is the understanding of why individual stock selection is so perilous—why, that is, investors find it so hard to pick winners and avoid losers.
Looking to the future, Langbein predicted:
Increasingly, the main work of the fiduciary investor will be what has come to be called asset allocation. The trustee will form a view of the needs, resources, and risk tolerances of the beneficiaries of the particular trust. The trustee will then decide what proportion of the portfolio to invest in what classes of assets. These choices will take the form of allocating the trust assets among large, diversified portfolios, primarily mutual funds and bank common trust funds.
The investment world of today is indeed very different from that of the past. The number and the variety of investment alternatives have increased dramatically, and the once well-defined boundaries between asset classes often are blurred. We now deal in a global marketplace. Exhibit 1.1 shows that the non-U.S. capital markets are as large, and therefore as important, as the U.S. capital markets. Computer technology delivers relevant new information regarding a multitude of investment alternatives almost instantaneously to a marketplace populated by both retail and institutional investors. The traditionally diversified U.S. stock and bond portfolio will become increasingly inadequate in the investment world of the future.
Designing an investment portfolio consists of several steps:
1. Deciding which asset classes will be represented in the portfolio
2. Determining the long-term target percentage of the portfolio to allocate to each of these asset classes
3. Specifying for each asset class the range within which the allocation can be altered in an attempt to exploit better performance possibilities in one asset class versus another
4. Selecting securities within each of the asset classes
The first two steps form the foundation for the portfolio's volatility and return characteristics and are often referred to as investment policy decisions. Traditionally, investment advisors have built diversified portfolios with three asset classes: cash equivalents, U.S. bonds, and U.S. stocks. They should, however, explicitly consider other asset classes—for example, non-U.S. bonds, non-U.S. stocks, real estate investments, and commodity-linked securities. To the extent that these various asset classes are affected differently by changing economic events, each will have its unique pattern of returns. It is the ability of one asset class's pattern of returns to partially offset another asset class's pattern that drives the power of diversification to reduce portfolio volatility. When considering which asset classes to include in the portfolio, the advisor should start from the premise that all major asset classes will be represented unless specific, sound reasons can be established for the exclusion of a particular class or classes.
The advisor can use a variety of methods to determine the target weights assigned to each of the various asset classes. Modern portfolio theory suggests that, in an efficient market, an investor with average volatility tolerance should hold a portfolio that mirrors the apportionment of the world's wealth among the various asset classes. This asset allocation would be similar to that shown in Exhibit 1.1.
In practice, however, clients vary considerably in their unique needs and circumstances. Thus, the use of one target allocation for all clients—"cutting the person to fit the cloth"—is not advisable. The client's investment objective, relevant time horizon, and volatility tolerance combine to determine whether the client should structure his portfolio for greater principal stability with correspondingly lower returns or, alternatively, for higher growth at the price of more volatility. In either case, the goal is to use the best allocation across the various asset classes in order to achieve the highest expected return relative to the volatility assumed.
For step 3, minimum and maximum limits are often set for each asset class's portfolio commitment. If, for example, stocks are judged to be unusually attractive relative to other asset classes, the proportion of stocks is moved to its upper limit. At other times, when stocks appear to be overvalued, the commitment is moved down to its minimum allocation. This represents the market-timing dimension of the investment management process. The success of market-timing activities presumes the existence of inefficiencies in the pricing mechanism among asset classes, coupled with the superior skill needed to identify and act on that mispricing. An extreme form of market timing allocates 100 percent of the portfolio to either cash equivalents or stocks, in an attempt to participate fully in common stock bull markets, while resting safely in cash equivalents during bear markets. The obvious danger of such an approach is that of being in the wrong place at the wrong time with 100 percent of one's capital. The minimum and maximum limits set for each asset class in step 3 act to minimize this risk by requiring that the portfolio avoid extreme allocations.
Market timers use various strategies in attempting to identify and exploit asset class mispricing. Technical analysis, for example, attempts to predict future price movements on the basis of the patterns of past price movements and the volume of security transactions. The overwhelming body of research evidence indicates that such approaches do not beat a naive buy-and-hold strategy. Other approaches rely on sophisticated forecasting procedures to determine the relative attractiveness of one asset class versus another. In essence, market timers claim to have the ability to identify asset class mispricing that everyone else misses and the decisiveness to act confidently on that foresight. A review of both the empirical evidence and the research done on the subject suggests that attempts to improve investment performance through market timing will most likely fail. In my judgment, the game is not worth playing.
For step 4, the advisor may recommend either active or passive security selection. If done passively, the advisor may recommend index funds for the various asset classes in order to obtain the desired breadth of diversification while minimizing transaction costs and management fees. Active security selection is predicated on the belief that exploitable inefficiencies, which can be identified through skilled analysis, exist at the individual security level. To add value, an active manager must produce an incremental return in excess of the transaction costs and associated fees—a very difficult though not necessarily impossible achievement.
The traditional viewpoint equates investment management with the third and fourth steps of the process—market timing and security selection. The probability for success in these areas is so low because of the tremendous intelligence and skill of the investment professionals engaging in these activities. Yet the first two steps in the process—the choice of asset classes and their respective weights in a portfolio—have had, and will continue to have, a large impact on future performance.
The focus of "value-added" investment advice is shifting decidedly in favor of fuller involvement by both investment advisors and their clients with proper asset allocation. By collaboratively exploring these issues and committing their decisions to writing in the form of an investment policy statement, both investment advisors and their clients gain the advantage of a shared frame of reference for evaluating investment performance and monitoring the progress being made toward the achievement of financial goals. Investment management is also demystified, and the likelihood increases that the client will adhere to a properly conceived, sound investment strategy during those phases of the market cycle when the temptation to depart from established policy is at its height.
If asset allocation is a major determinant of portfolio performance, why do investment advisors and investors obstinately focus so much attention on security selection and market timing? Part of the reason is historical. The money management profession is rooted in the notion that superior skill can beat the market. Many investment professionals secretly worry that, were it not for the expectation of superior results from security selection or market timing, they would be out of a job.
(Continues...)
Excerpted from ASSET ALLOCATION by ROGER GIBSON. Copyright © 2013 by McGraw-Hill Education LLC.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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