September 28, 2009
STRATEGIC PERSPECTIVE IS (STILL) A RADICAL IDEA
Investment advice runs the gamut in the known universe of finance. Some of it's good, some of it's less so, but the majority of it is just plain misguided if not detrimental to the long-term interests of investors. It's an old story, but it's also a perennial, and therein lies the problem for most people trying win (or at least not lose) in the money game.
The central challenge for the average investor, perhaps even the average institutional investor, is that the global capital markets are rife with complication, short-term noise, nuance and lots of trap doors. Adding to this burden is the fact that much of what passes as investment intelligence is anything but, mainly because it lacks perspective and basic understanding of the essential business of portfolio design: risk management. There are simply too many "experts" running around dispensing advice to buy this, avoid that and otherwise recommend that investors engage in an ill-advised effort to second-guess market prices at every turn.
Yes, there are some who can beat markets, but it's the rare individual investor who excels in picking securities across multiple asset classes. We take a different view in the monthly issues of The Beta Investment Report. Instead of starting from the belief that we have full clarity on the future path of risk and reward for the global capital and commodity markets, we assume that a fully diversified portfolio of all the major asset classes, weighted by the market values, is a robust benchmark from which to begin analysis and ultimately tweak Mr. Market's passive allocation to suit our financial needs.
It's a radical idea, based on what passes for standard operating procedure in terms of counsel in the media and the offices of financial advisory. But it's a strategy that draws strength from 50 years of economic research and quite a bit of supporting empirical evidence that tells us that this is a logical and productive way to begin our investment journey.
That's one reason why we regularly profile the major asset classes each month on these digital pages, as we did early this month here, in our end-of-month update. We go into much more detail in The Beta Investment Report, but the basic goal is the same: strategic perspective. It's not a short cut to quick profits, but it's a valuable way to begin the all-important task of gaining perspective.
Looking at past returns by itself isn't enough, of course. We must also consider how a passive mix of the major asset classes has performed over time, and how this benchmark's risk profile evolves amid the give and take of market and economic trends. In addition, we need to keep an eye on the major asset classes individually by studying them, tracking them and comparing how the price of risk varies today vs. the past. Another critical element is paying close attention to the business cycle with an eye on understanding how it unfolds, where we're at currently and what the trend implies for the near-term future over, say, the next three to five years.
Ultimately, the goal is one of becoming comfortable with estimates of risk premiums for the major asset classes, individually and collectively. With that information in hand, we can begin thinking about how to reassemble Mr. Market's passive asset allocation for building portfolios to suit our own needs. Indeed, everyone (and every institution) should customize asset allocation to satisfy a particular set of financial circumstances, including a unique set of liabilities and expectations.
The default strategy (not to mention an easy strategy) is simply buying all the major asset classes and weighting them by their relative market values. But this is the optimal decision only if you have an infinite time horizon and generally fall into the category of an average investor in terms of risk and return needs and expectations. To the extent that you don’t fit that profile—and nobody does—there's a case for adjusting the passive asset allocation.
What does "adjusting" mean? A whole lot more than we're prepared to write about in one blog post. That's one reason why we publish The Beta Investment Report, which goes into the details on a monthly basis, including analyzing the major asset classes; reviewing the associated index mutual funds, ETFs and ETNs; reviewing new investment research that furthers the goal of enhancing our strategic portfolio perspective; tracking the broad trends in the business cycle; and more. For readers who're interested in a relatively comprehensive and formal argument for this approach in one fell swoop, your editor has written a book on the topic and it'll be published by Bloomberg Press in February: Dynamic Asset Allocation: Modern Portfolio Theory Updated For The Smart Investor).
Depending on who you are as an investor, you may dispense with some, most or even all of Mr. Market's asset allocation. But for most folks, drifting too far from the true market portfolio—as defined by our Global Market Index—is probably a mistake. Simple statistics dictates that half of the world's investors will trail a passive mix of the major asset classes in the long run, and perhaps over the short- and medium-term periods as well. After adjusting for taxes and trading costs, it wouldn't surprise us to learn that quite a bit more than half will trail this benchmark.
On that note, our Global Market Index, which is comprised of a passive mix of the major asset classes, generated an annualized total return of a bit more than 4% for the 10 years through the end of August 2009. By comparison, the U.S. stock market (Russell 3000) was just about flat over that period and U.S. investment-grade bonds (Barclays Aggregate Bond Index) rose by 6.3%. Did your portfolio beat GMI? If so, how much was due to luck vs. skill? And if you trailed it, well, are you prepared to change your strategy?
To follow this not-exactly-fair example through to its logical conclusion, one might ask: What was the average investor thinking about ten years ago? Recall that in the latter half of 1999, few were arguing on behalf of bonds while much of the conventional wisdom called for stocks in large if not overwhelming quantitites for the long run.
The point is that most predictions are vulnerable, especially when looking out over multi-year periods. The fact that mere mortals are generally at a disadvantage in this regard is a potent reminder that we should think twice before dismissing the true market portfolio as a basic framework for designing and managing portfolios through time. But even this simple but powerful advice is ignored in the wider world.
That's not terribly surprising if you consider that investment perspective rarely looks useful or even compelling in the short term, as suggested by our review of recent trends in the major asset classes. But just as sure as the sun will rise tomorrow, ignoring the strategic issues is likely to incur a toll, perhaps a heavy or even fatal toll on investment results. Recent history makes this point in no uncertain terms, as does a broad review of the capital and commodity markets and decades of research from financial economists. Why, then, do so many seem to ignore strategic perspective? We have our theories, although a formal attempt at answering the question is beyond our job description.
Meantime, we now return you to the investment casino game already in progress….
Posted by jp at September 28, 2009 10:10 AM
Good post. A lot of advisors could read your post to thier clients verbatim and be more than OK. Well done.
Posted by: Ember Martin at September 30, 2009 1:23 AM