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Obsessing Over The Trees (And Overlooking The Forest)

 December 27, 2012 09:17 AM


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 interview implies.

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.
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