What are the odds of getting it right? Tougher than it seems. Maybe that’s why there’s a widespread tendency to assume that asset allocation doesn’t require much analysis or monitoring. Some folks take this to the extreme and decide that asset allocation isn’t all that important after all (even if quite a lot of research tells us otherwise). But what you own and when you own it, and how much of it sits in your portfolio, counts for a lot, as my current profile of the major asset classes reminds. The problem is that there are a lot of moving parts to researching, building and maintaining a diversified portfolio and so getting it all right is, well, let’s just say it’s challenging.
In fact, the more you understand the challenge that awaits, the more likely you’ll hedge your bets by sticking close to Mr. Market’s asset allocation. Unless, of course, you’re confident that your skills at divining the future are above average if not impeccable. But if you’re among the overwhelming majority of investors (individual and institutional), the financial equivalent of the burden of Sisyphus awaits.
Imagine that you’re invested across 10 asset classes. On any given day, the goal is to hold the optimal mix that captures the maximum expected return with the least amount of risk. Unfortunately, no one’s ever sure of how to define that benchmark until well after the fact. Choosing the correct allocation in real time is virtually impossible, particularly if we’re required to do so every day.
Trading costs, taxes and other frictions limit us to relatively infrequent portfolio changes. But even then the odds are low that we’ll pick the right mix at the right time, every time. That inspires hedging this risk by holding a wide assortment of assets and steering clear of extreme decisions on relative weights. This isn’t likely to deliver optimal results either, but it’s a reasonably good strategy for staying out of the performance ditch, as a comparison of how simple diversification fares against professionally managed asset allocation strategies.
Why is it so hard to identify the optimal asset allocation (or something close to it) on a regular basis? The short answer is that the drivers of risk and return are extensive and the interactions complex and so it’s all far beyond our capacity to optimize. That doesn’t stop anyone from trying, but the results are generally mediocre at best. Mediocre results aren’t the end of the world, unless you’re moving heaven and earth (and paying a steep price) for something that can be generated relatively easily and inexpensively.
This simple bit of advice tends to be ignored. The allure of focusing on one asset class at a time, and obsessing over its outlook, keeps us from concentrating on those variables over which we have some limited influence, namely, asset allocation and rebalancing. In fact, most of your success (or failure) will be closely tied to how and when you rebalance across time. True for an ETF-only portfolio, and true if you hold individual securities. That inspires the question: What’s your rebalancing strategy? Is coming up with an answer where you spend most of your time in matters of investment analysis?
Even if you could somehow identify the optimal initial asset allocation for your portfolio, the final results of your investing travels will be determined by the rebalancing strategy. That’s another way of saying that most of your research, analysis, and monitoring should be directed at how the assets you own interact. Given the history of realized performance results in the world, it’s no surprise that this crucial topic is where most of our collective intelligence is weakest.
It’s easier, of course, to obsess over individual securities and asset classes, one day at a time, in isolation. But don’t confuse intellectually comforting preferences with strategic wisdom.