Jason Zweig’s latest investing column in The Wall Street Journal is disturbing, but not necessarily for the reasons he outlines.
Consider this passage: “…many investors who followed the best advice were punished the worst. Someone who held a total-stock-market index fund lost more than 58% from October 2007 through March 2009 and remains 31% behind even after last year’s recovery. ” Zweig goes on to note that “these people can’t blame themselves; they did as they had been told.”
My first reaction is to question who was handing out “best advice” that recommended owning a stock-index fund in isolation? Okay, let’s be generous and assume that the equity index fund was owned along with other funds that targeted other asset classes. Even then, analyzing an equity index fund alone, rather than in concert with the entire portfolio, offers a distorted view of portfolio strategy. So too does using a short time frame for assessing success or failure. If you’re day trading, presumably you understand the risks. But if you’re a medium-to-long-term investor, reviewing recent history as the last word on portfolio strategy is a bit like trying to figure out the value of a car by looking only at the tires. It’s certainly easy, but not very productive if we’re looking for strategic-minded intelligence.
If we step back and consider what financial economics has taught us over the decades, the first rule is to own a broad mix of asset classes. The starting point is simply to own everything, in its market-cap weight. We calculate such a benchmark–the Global Market Index–for our monthly newsletter, The Beta Investment Report, which focuses on asset allocation design and management using ETFs and index mutual funds. As we discussed earlier in the week, this know-nothing portfolio has generated a modest gain over the past 10 years: a 3.9% annualized total return vs. a slight annualized loss for the S&P 500 (-0.8%). In addition, a mindless rebalancing of the multi-asset class portfolio at the end of each year raised the 3.9% annualized total return by around 90 basis points.
In other words, an investor who diversified broadly, across all the major asset classes, and simply rebalanced every December 31 back to initial weights, would have earned a modest return over the past 10 years. What’s more, this isn’t rocket science, nor is the concept particularly new.
As I explain in my new book, Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor, financial economics has been dispensing prudent advice for portfolio strategy for decades. Even better, there’s a constant stream of new intelligence on asset pricing and portfolio design. When you boil it all down, the first step is owning a broad mix of asset classes—i.e., asset allocation. Step two, rebalance the mix. Yes, there’s lots of nuance in those steps. Fair-minded people can debate certain details in the real-world oversight of portfolios. Indeed, there’s also sorts of issues to consider, much of which comes down to deciding how you differ from the average investor. But as a basic proposition, this pair of rules is a pretty good starting point for designing an investment strategy.
Should we deviate from rules one and two? Should we employ additional rules? Perhaps, but you’ll need a compelling reason, a bit of skill and a deep understanding of asset pricing and how markets can deviate from equilibrium. It would help if you’re smarter than the average investor. A more plausible reason to do something different than simply own the broad, passively managed market portfolio is that you have a different risk tolerance and investment objective than the average investor.
But it all starts with steps one and two: asset allocation and rebalancing. This constitutes the foundation of the “best advice” that decades of financial economics has dispensed. If we were talking of medicine or aviation, the advice would be widely embraced. But this is finance and so what constitutes prudent counsel is regularly ignored or dismissed.
Does this mean that broad-minded asset allocation and routine rebalancing is a guarantee of investment success? No, of course not, particularly in the short term. If you absolutely must have a guaranteed income over the short and even long term, you probably shouldn’t own the market portfolio. At the very least, it should be a small part of your investable assets. On the other hand, if you tolerate some risk, can live with volatility in the short run, and you need to earn something more than the risk-free rate in the years ahead, the basic framework for tackling the challenge is clear.
There are no perfect solutions in the quest to earn a risk premium, but some choices are better than others.