Nate Geraci
February 18, 2009
Some things really do “never” change. Take, for example, the drumbeat we hear, every time there’s a meaningful downturn in equity markets, of those good ol’, familiar, “tried and true”, “Stocks & Bonds Allocation ABCs” vibes from a seemingly endless parade of would-be allocation medics.
But what have we learned over the last forty years about asset allocation and how have conditions and secular trends of the past 20 years impacted and shaped the asset allocation mind sets and perceptions of risk which investors have carried into the most recent downturn?
Harry Markowitz’ work on Modern Portfolio Theory (MPT) long ago got nearly everyone in the investment room to at least acknowledge the importance of diversification across and within asset classes. But, in practice, certain lessons remain to be learned. 1) While diversification is achieved by combining uncorrelated assets into a portfolio, nowhere did Markowitz’ work suggest an investment universe limited to stocks and bonds alone or to the exclusion of any particular asset class (e.g. commodities, currencies, REITs). 2) Correlations are dynamic … witness the capital flight from nearly all non-treasury assets to the safety of treasuries during the most recent downturn. 3) Discipline – dare I say it? It’s one thing to have a strategy that, by virtue of its design, warrants sticking to through thick and thin (and many are not so-designed). It’s quite another to have the conviction to actually stick to it.
My hunch is that in 2015 or 2020, historical economic chart visuals and timeline displays will likely block off nearly two-decades stretching from the late 1980s through the late 2000s as a period during which a fairly stable mix of equities and bond-friendly conditions and trends predominated. Highlighted will be secular declines in interest and inflation rates, punctuated by brief “corrections” where diversification across equity and bond assets alone got the job done reasonably well. These are what we’ll regard as the key tectonic features and shapers of both investment thinking and investment activity. The relatively narrow equities / bonds view of what constitutes the relevant and necessary asset universe, of course, “works” reasonably well in that sort of environment.
Equities and bonds are, of course, primary, critical and core allocation components. But if we are, in fact, wading into an extended period of weak growth that may, ultimately, be combined with the bite of inflationary pressures, the two asset allocation wheels (stocks and bonds) alone may make for a very, very long and far less than pleasant ride.
Strategic thinking, consistently reinforced over the last twenty years, I’m afraid, has got us into a sort of Pavlovian allocation funk – Ring the volatility bell, move once again (in crisis mode) to review, evaluate and beat to death the equities / bonds allocation strategic mix. And, when it gets difficult to breathe and it “feels” refreshingly right, let’s resort to crowning “cash” (a.k.a. very short-term fixed income) as “king” and an asset class in its own right, serving as the life-saving third wheel.
I believe that by 2015 or 2020, the investing world might rather fully regard what we currently loosely term “alternative” investments as a full-fledged, well-defined asset class encompassing commodities, real estate, currencies and a relatively narrow, related subset of “demographically-advantaged” equities.
Few of today’s investment managers have professional experience stretching deeply into the 70s — a time when all but the largest of institutional investors lacked access and/or expertise to manage exposure in “alternative” asset areas. It is interesting, and timely, that during the last two or three years we’ve managed to arrive at a far better-stocked tool box. And, yet, most investors and advisors still see the investment space only in terms of the hammer (equities) and screwdriver (bonds). Oh, what many a 70s/80s manager would have given to have the breadth and purity of access to assets on a par with today’s retail investor (at least in hindsight, right?)! But, of course, visual acuity and skill beyond these two dimensions haven’t really “mattered” so significantly since those difficult times that ultimately drove many to don leisure suits and resort to listening to the Bee Gees et al.
But that’s not to suggest that the world is all that complicated either. The name of the game, quite simply, is quality return potentials combined with true diversification into less than perfectly correlated assets – always has been, always will be. And I think that this might be close as we’ll ever get to a universal truth in the investment management business.
Unfortunately, most investors and advisors are entirely in left field – or, rather, miles beyond the left field fence – when it comes to recognizing sources of concentration risk which they hold while, concurrently, carrying pockets of severe under-exposure. Take a look under the hood, for Pete’s sake! What is the composition of your aggregate equity portfolio holdings in terms of market capitalization and growth/value and sector composition and dispersion? Over time, how variable are these concentration characteristics? What are the quality-composition and distribution and issuer concentration profiles within the body of fixed income holdings? What about duration and currency distributions of those fixed income holdings? What is the nature and size of exposures to commodities, currencies (through equities, fixed income and currency instruments), real estate, emerging industries in the US and globally? If “diversification” is part of your risk management m.o., which attributes do you set out to monitor, manage and contain, which do you allow to float and how do you track the package?
The real starting point for all of us is to know what you currently hold – areas of concentration risk and pockets of under-exposure and, then, systematically moving to contain and allocate according to what actually limits concentration and under-exposure – beyond what any stocks/bonds “only and forever” allocator “purist” would have you do. And beware of “… it’s worked for the last 20 years …” feel-good validation techniques. True containment of concentration risk and true diversification into meaningful areas of under-exposure are what was needed in the 70s and 80s – but such capabilities weren’t accessible to the masses. Generically speaking – investors of the 70s and 80s, whether so inclined or not, couldn’t invest in “alternative” assets and, consequently, were stuck with choices that were doomed to messy and highly correlated fates in the stagflationary environment of the time.
While we’ve got a far from perfect menu, we have the basic tools to get the job done better, perhaps, than even the best-equipped institutional players of the 70s – without aiming to “time” the vagaries of the business cycle. And that means more than just dining on steak and potatoes.
