Striking the right balance with asset allocation

Harry Markowitz, Nobel laureate in economics and a pioneer in investment theory suggested that a fundamental responsibility of any investor is to manage the risk of their portfolio. The risk he was referring to is volatility: the ups and downs of stock prices during the year and from year to year. Investors who ignore risk in pursuit of returns expose themselves to intolerable portfolio declines prompting them to abandon their plan thereby converting temporary losses into permanent ones. Conversely, those who choose to minimize or avoid volatility entirely must be willing to accept returns that may prove insufficient to fund their future goals.

The world’s capital markets are comprised of different asset classes each with their own risk and return characteristics. The three major categories are stocks, bonds and cash. A portfolio’s distribution across asset classes refers to its asset allocation. Sophisticated investors have known for decades that asset allocation is the most significant determinant of a portfolio’s performance. Landmark studies published in the 1980s and 1990s analyzed the returns of large institutional plans and confirmed the crucial role of asset allocation estimating that it explains more than 90% of a portfolio’s returns and volatility over time. The message for all investors is that asset allocation is far and away the most important part of designing a successful portfolio.

In general, stocks provide the growth engine for the portfolio. The higher the allocation to stocks the higher the expected investment returns and along with it the greater the volatility. Bonds, on the other hand, offer stability, but not much long-term growth potential especially after accounting for inflation.

The appropriate mix of stocks and bonds will strike a comfortable balance between growth and stability and reflect the individual investor’s financial goals and ability to handle risk. Investing is often framed as a choice between eating well as a result of high stock market returns and sleeping well from the stability that bonds provide. The implication is that investors must choose one or the other. Markowitz showed us that a sensible asset allocation allows us to do both.

Are you getting compensated for investment risk?

While there are various types of investment risk, the proxy most often used by investment professionals is a statistical measure known as standard deviation. In basic terms, standard deviation indicates how volatile and unreliable the returns of an investment can be. The more volatile the expected returns, the higher the standard deviation and risk because the chance of experiencing a large loss on the investment is greater. For these reasons bank savings accounts, high-quality bonds and stocks have low, moderate and high standard deviations respectively. Because risk and return are correlated, we can expect (but are not assured of) higher returns from stocks than bonds and higher returns from bonds than savings accounts.

In 1952 Harry Markowitz, a Nobel laureate in economics and a pioneer in the area of finance known as Modern Portfolio Theory (MPT), proposed that both math and common sense suggest that investors should consider both risk and return when making investment decisions. Furthermore, because investors are risk averse, they should demand suitable compensation for taking on risk. A rational person, therefore, will only invest in riskier securities if they believe that the expected returns on those securities will be high enough to warrant taking on the risk. Otherwise, a prudent investor would choose less risky but equally profitable alternatives.

There are two central and related tenets of MPT that have important implications for the everyday investor. First, by mixing different types of stocks that move up and down independently of each other, investors can reduce the volatility of their overall portfolio. This is known as diversification. Markowitz further demonstrated that while diversification reduces portfolio risk it does so while maintaining and potentially enhancing returns. This is why diversification is considered the one “free lunch” in finance. Second, because risk reduction through diversification can be easily achieved, the financial markets do not reward investors who fail to diversify their holdings. The result is what many investment theorists refer to as uncompensated risk.

Risk and return go hand in hand. However, for stock investments, this relationship only holds true once they have been effectively diversified.  Empirical research has shown that as investors move across the spectrum from broadly diversified portfolios to those consisting of concentrated positions they become increasingly exposed to uncompensated risk. In other words, there is additional risk for which they do not receive a commensurate return. At the extreme, some investors may hold a highly concentrated position in a single company stock, but more typical are those whose financial assets are skewed toward a small group of sector funds.

Sector funds are those that invest in a narrow slice of the market such as an industry like biotech or banking or a specific region of the world such as China or Brazil.  They are diversified within an industry or geographic region but still expose the investor to unnecessary concentration and uncompensated risk. The explosion in niche exchange traded funds (ETFs) has attracted legions of investors who believe they possess superior insight into certain sectors.

There is no such thing as risk-free returns when it comes to investing. Those seeking to avoid risk will also avoid potential returns. Markowitz taught us that smart stock market investors focus on controlling risk, not avoiding it. The most effective way to accomplish this is by building a broadly-diversified portfolio rather than placing a big bet on a particular stock, industry or country. Once the unnecessary risk has been wrung out of the stock portfolio, the only one that remains is the risk inherent in investing in the market itself. This risk is unavoidable and for most investors will be challenging enough to handle.

Beware of “expert” financial advice – Part Two

In my last post, I talked about the newest book written by self-help coach Tony Robbins, “Money: Master The Game.” A portion of the book is dedicated to his human performance and achievement philosophy as it relates to financial success. In the next section of the book, he offers some useful information including common sense principles like spending less than you earn, starting a savings program early and allowing compound growth to work its magic.

It’s the last part of the book where Robbins offers specific investment advice that I would like to address. He makes reference to the investing “secrets” of the ultra wealthy and how they can be applied to even the smallest portfolios. Robbins also claims to be able to show the average person how to take minimal risk and still be able to reap big rewards. To get what Robbins calls the “upside without the downside,” he proposes several investment vehicles, including structured notes, market-linked CDs, and fixed indexed annuities. Investors are likely to encounter these products in a variety of forms, each with different contract terms and conditions and potential risks. However, they will almost certainly share the following characteristics:

  1. Complexity. This means they are good for the seller but bad for the buyer. David Swensen, the head of Yale’s endowment fund sums it up by saying “As a general rule, the more complexity that exists in a Wall Street creation, the faster and farther investors should run.”
  2. The subject of numerous investor alerts and bulletins from concerned federal and state regulators.
  3. Marketed aggressively by investment firms and their sales representatives when markets are down and investor anxiety is high.
  4. Loaded with commissions and fees that investors will pay for in one form or another. This compensation structure can lead to sales practice abuses.
  5. Almost universally misunderstood. If everyone applied the basic rule of investing “If you don’t understand it don’t invest in it”, sales of these products would go to zero.

The simple fact is, in most cases, an intelligently constructed portfolio of broadly diversified, low-cost funds will provide investors a superior solution at a fraction of the cost.

Robbins does deliver a portfolio allocation recommended to him by his friend, billionaire hedge fund manager, Ray Dalio. Robbins calls it the “invincible, unsinkable, unconquerable, all-seasons strategy” because of its ability to “perform well in good times and bad – across all economic environments.” The portfolio consists of 30% stocks, 55% bonds and 15% in commodities and gold. Although investors could do worse, there are a few reasons why they should be wary about modeling that approach.

First, every investor’s personal and financial situation is different as is their emotional and financial ability to handle the downturns in the markets. A 55% allocation to bonds will be right for one person and not for another.

Second, the author uses back testing, a process of applying historical returns to a hypothetical portfolio to support his case. This can show how the portfolio has performed but not how it will perform.

Third, this is a bond-heavy investment plan that benefited from a 30-year period during which the Fed drove down interest rates pushing up bond values. Since rates are near record lows, it’s very possible that the All-Seasons portfolio will not be as productive going forward as it was in the past.

Fourth, the recommended portfolio includes an allocation, albeit a small one to gold and commodities. Both of these assets are volatile, generate no dividends or interest, and have long-term expected returns equal to the inflation rate. Their benefits as portfolio diversifiers and inflation hedges are unpredictable at best and questionable at worst. They take up room in the portfolio that could be used to generate better long-term returns.

I recognize that it’s a lot easier to critique a book than to write one and I applaud anyone for attempting to tackle such an important and complicated topic like money and investing. However, I think that in trying to cover as much breadth as he did, Robbins may have undermined some of the many important and valid points he did make. Bottom line: like all personal finance-related literature targeted at consumers, the book should be read with a critical eye.