Wall Street has taught most financial advisors that it is a waste of time to manage their degree of exposure to risky assets. Finally, however, in his February 2010 Financial Analysts Journal article, asset allocation guru Roger Ibbotson observes that “the idea that “asset allocation policy” explains more than 90 percent of performance has become accepted folklore... The time has come for folklore to be replaced with reality. Asset allocation is very important, but nowhere near 90 percent” as claimed by traditional industry thinking.
Indeed, asset allocation is extremely important – but the famous Brinson, Hood and Beehower article, “Determinants of Portfolio Performance” published in 1986, never concluded that a static policy is therefore best.
But as a result of the traditional interpretation of that 1986 study, nearly all financial advisors place clients in a static (never changing) mix of stocks, bonds and/or cash. In nearly every market environment, and in all economic conditions, investor allocations to the magical mix stay constant. As a result, clients pay advisors significant fees but get no real advice in return about when to increase or decrease exposure to stocks, the asset class most likely to cause investors to lose money. In addition, clients underutilize stocks because many are unwilling to accept so much portfolio volatility through good times and bad.
Upside volatility is great, but downside volatility is what investors remember. In fact, the entire industry gets accused of doing nothing for their money, when part of what financial advisors deliver is general financial planning advice, but advisors price it in the value-added clothing of a true investment manager. Consequently, consumers neither seek nor get either financial planning advice (which they probably need) or investment allocation advice (which they want, but can’t find an advisor willing to provide this guidance).
Many advisors have replaced actively managed portfolios with an indexing approach, but indexing leaves clients vulnerable to market volatility because they are forced to “buy and hold” through all types of markets. Investors who cut back on equities may have to reduce return expectations and, therefore, their standard of living in retirement, and reducing equity exposure leaves investors more vulnerable to inflation at a time when inflation is creeping higher and shadow inflation statistics suggest that the real level of inflation is much worse than is officially reported.
May-Investments solution is to allow “Beta” (the fancy statistical name for portfolio volatility) to vary so that in high risk markets, clients aren’t completely exposed to a huge market decline. If “asset allocation policy” is the most important determinant of portfolio return (and it is), then a flexible Beta approach allows a portfolio’s allocation to stocks, bonds or cash to vary according to the current economic environment and market opportunity set investors face.
A flexible approach allows risk to be reduced during the most dangerous times. In addition, cash can be set aside so that it is available to repurchase stocks when either risk is reduced, or stock prices become more attractive. By timing markets (imperfectly, but as well as we can), we can transform volatility from merely being a statistical proxy for market risk into the generator of opportunity for future returns. Buy low, sell high. Isn’t that the idea?
Galileo was considered a heretic for supporting heliocentrism, and most traditionalists in the financial services industry view our approach with equal disdain. Galileo spent the last nine years of his life living under house arrest, condemned by Pope Urban VIII’s inquisition of being “vehemently suspect of heresy.” There is no substantiation to the rumor that he recanted at his trial by muttering the rebellious phrase, ‘I could agree with you – but then we would both be wrong.’
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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