With the year nearly complete, what have we learned in 2012 from an
investing perspective? The main lesson is a familiar one, but one that
is too often trampled under the noise of the moment. Focusing on the
portfolio is (still) the primary objective, as Markowitz told us
all those years ago. More than half a century later, theory and the
empirical record are in rare state of agreement: portfolio design and
management take a back seat to nothing as critical factors for
engineering investment success.
It's a simple idea and, more importantly, an effective one in terms
of improving the odds of achieving your financial goals. But as many
studies have documented, relatively few investors (either as individuals
or institutions) excel in leveraging asset allocation to its full
potential. The stumbling block can't be blamed on technical issues. As
the numbers show on a fairly consistent basis, simply diversifying
across a broad set of asset classes
and routinely rebalancing the mix has a history of generating
average-to-above-average returns relative to crowd's efforts overall.
That doesn't sound like much, but when you study the data it's clear
that average to above-average vs. everything ends up delivering fairly
impressive results. All the more so once you recognize that there's a
high degree of confidence that you'll earn average-to-above-average
returns when you diversify broadly and rebalance regularly.
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This isn't rocket science, even if some people treat it as such. That's the message from my own research, and it's a theme that persists in the literature as well, as I noted in my book, Dynamic Asset Allocation.
Sure, there's a sea of studies and quantitative issues to wade
through if you're so inclined. But at the end of the day, it's all
fairly intuitive and accessible. But success still eludes most folks,
and I think I know why: An excessive focus—an obsession, really—on the
parts, one at a time, while ignoring or at least minimizing the whole.
Markowitz told us to avoid this pitfall, but it's the norm in the
grand scheme of investing. It's easy to see why. Most of the discussion
on matters of investing zero in on specific trades and asset classes. A
quick example: bonds.
It doesn't take a Ph.D. in finance to recognize that there's far more
risk in, say, a 10-year Treasury today vs. 10, 20 or 30 years ago. Why?
The current yield on the benchmark 10-year note has fallen to record
lows. It's a dramatic decline, particularly when viewed through time.
The chart below is dramatic, but it shouldn't be used as an excuse for
dramatic changes in asset allocation, at least not all at once.
The reasoning is that if your diversified portfolio included exposure
to 10-year Treasuries all along, and you've been practicing a
disciplined regimen of rebalancing through the years, the portfolio has
been a) routinely capturing a portion of the capital gains thrown off by
falling yields; and b) keeping a lid on the 10-year's weight in the
overall asset allocation. Prudent risk management, in other words.
So, what's the problem? The trouble starts because the demand for
excitement and drama in financial media tends to overshadow the boring
narrative of asset allocation and rebalancing. The fundamental lessons
for money management don't change much, if at all, through time. That's a
problem if you're looking for new story ideas.
Boring doesn't sell magazines, juice traffic on web sites or gin up
drama in a TV interview. But unexciting concepts in the cause of
strategic investing success work, and so they're not easily dismissed if
you're intent on building wealth over medium- to long-term horizons.
Keep that in mind the next time you watch an interview with the analyst
du jour asserting that a given asset class is a strong buy or sell. The
advice may impart useful information, but don't get too worked up about
it. First, he could be wrong. Yes, that happens every so often, or so
I'm told. Two, if you own a broad mix of assets (and you should), any
one slice of the portfolio isn't nearly as important as today's exciting
There's nothing wrong with analyzing asset classes in isolation and
projecting risk and return. I do a fair amount of it myself, and it's an
essential process, although not necessarily for the reasons typically
cited. But it's almost always a mistake to analyze a single asset class
outside of the context of a broadly diversified portfolio--your
portfolio, to be precise. Asset class X may look awful on an ex ante
basis, but if it does—and you've owned it all along—it'll probably have a
relatively low weight in your portfolio. And if you own a lot of it,
well, that's a sign that it's time to rebalance, regardless of the
outlook. Why? Because asset classes—we're not talking individual
securities here—tend to have low or negative expected returns after a period of the delivering the opposite.
That last point is arguably the single-most important piece of
strategic portfolio advice for investors. But it's also worthless
without a broadly diversified asset allocation strategy.