Five years is a long time. Long enough to shatter old myths, forge new ones, and remind investors that luck is no trivial factor. A little skill couldn’t hurt either. In any case, we submit for your consideration the trailing five-year annualized returns for the major asset classes through yesterday, followed by some observations.
What jumps out at us is the performance dispersion, which is to say the robust variety of returns–ranging from more than 20% a year for REITs down to just over 1% a year for the S&P 500, a.k.a. large cap domestic stocks. The point being that there’s been no shortage of opportunity and pitfall in the global capital markets in the last five years. There never is. The winners and losers keep changing, but you can always count on a broad assortment of returns over time for the major asset classes. The not-so-subtle implication: asset allocation still matters, and more than a little.
The mother of all strategic issues in money management all too often becomes subsumed in the chase for the next hot stock. But anyone interested in investment success as a durable notion beyond the end of the month should ignore the widespread obsession with short-term tactical.
The fact that asset allocation is no less relevant in the 21st century than in the preceding generations comes as no shock. Indeed, 2006 is the 20th anniversary of the seminal research from “Determinants of Portfolio Performance,” the 1986 paper in the Financial Analysts Journal that first proclaimed the overwhelming influence of asset allocation on portfolios. Market timing and security selection, by comparison, were found to be relatively inconsequential factors regarding diversified portfolios over time.
The eternal question, of course, is what’s an enlightened asset allocation going forward? A difficult query to answer, even for an enlightened student of money management. In turn, that suggests investors should spare no effort in coming up with an informed guess, or otherwise hiring someone to do the dirty work.
With that in mind, it’s worth remembering that nothing goes up or down forever, at least when it comes to asset classes. Individual securities come and go, but asset classes are forever. That may be small comfort, but it’s more than you can say for any particular company or bond. The Acme Computer Co. may hit the skids tomorrow, but equities overall will be here long after we’ve become fertilizer. Accordingly, paying attention to reversion to the mean (otherwise known as portfolio rebalancing) is one of the few worthwhile pursuits in the study of market history.
Timing, alas, is a crucial part of the equation, at least in the relatively short run. So while we can all congratulate ourselves in recognizing that the REIT group has been one of the globe’s hottest asset classes in the last five years, or that the large-cap U.S. equity sector has been a dog, deciding what to do about it for the next five years is another matter.
Inching toward an answer starts with deciding what your “normal” weight in each of these assets should be. “Normal” here is defined as a long-term weighting a la a pension fund’s infinite time horizon. For some, that means something approximating the current weight of the asset class as calculated by its relative market cap within the global capital markets. However you calculate it, coming up with a normal weight is fundamental. Why? Because if REITs, for instance, are deserving of a 10% normal weight, then the challenge at any given moment is deciding how much to deviate, if at all, from the normal weight, either with an overweight or underweight.
Coming up with intelligent answers takes time, a bit of number crunching, and in the long run some luck. But for the moment, we can start with step one: knowing where we’ve been, which hopefully can shed a tiny bit of light on where we’re going.