A Fool’s Errand

July 13, 2006 by  


By Bob Wood

During the past week, I had the opportunity to discuss my investing themes with some other financial professionals. One is an aspiring money manager and the other serves as a middle man of sorts, directing client money into managed portfolios of index funds. Both swear by the accumulated knowledge known as “Asset Allocation.” My argument against this method, as I wrote in this column a year ago, remains that the most widely accepted method for building and managing an investment portfolio is a fool’s errand, a sure way to gain nearly nothing — in real terms. If you are already shaking your head in disbelief, let me explain.

Asset allocation studies began about 50 years ago at the University of Chicago. There, some really bright graduate students of Finance became convinced that they could apply their newly-gained knowledge to construct investment portfolios and employ the best way known to man for managing risky assets like stocks. Their theory, they believed, would bring the best possible returns for the amount of risk taken.

Since no one else at the time had any real method or system in place for diversifying investment risks, their goal was laudable, to be sure. And to an extent, they succeeded. They introduced a method that became known for reducing risk and offering the most efficient way to make long-term gains from the stock market.

How, you might ask, could shifting to a more diversified portfolio be a bad thing? After all, diversification is widely acknowledged as a smart way to invest, isn’t it? And two people won a Nobel Prize in Economics for their work on diversification methods known as Asset Allocation.

Who could possibly find fault with the most widely-held belief regarding what works for investors? As someone who values what is different in all things, I can point out several problems with this approach.

The purpose of the Asset Allocation method is to help reduce the risk of losing a lot of money in stocks. And that’s not a bad idea, especially for anyone with vivid memories of our recent bear market. The method, which has become widely recognized as superior to all others, has gained widespread use, and therein lies the first problem. When most everyone does the same thing, the method becomes less effective.

Another problem I see with using asset allocation and diversification is that the greatest investors of our time don’t go anywhere near using this approach. Does Warren Buffett build and manage a well diversified portfolio, making sure to include “proper amounts” of small-, mid- and large-cap stocks? How about George Soros? or Jim Rogers? Ah…nope!

Another point on my growing list of objections to managing portfolios in this traditional, well-diversified way is the glaring hole emerging in its validity. I frequently ask Asset Allocation proponents to count the number of investors they know or have heard about who became rich investing in this way. The typical response is ‘’No one.’’ So why do we see so much belief in the merits of a method that seems never to have proven effective?

As an example, look at the intrepid investor in Japan over the past 15 years, who commonly would have allocated the core portion of his portfolio to the home market, the Nikkei. How would Asset Allocation have worked while that index dropped from about 39,000 to 8,000 in 13 years? How will it work in the U.S. when the Dow or S&P reaches the bottom of our current secular bear market, possibly many years in the future, as I firmly believe it will?

Logically speaking, the next obvious question is: if diversification is the most widely accepted method for managing investment portfolios, why haven’t numerous individual investors made small fortunes in stocks? And why do investors think that what hasn’t worked previously will suddenly emerge as a winning strategy — just because they have adopted it? My financial professional friends believe they assert some special ability for working this method better than most others, thus verifying ‘’their edge.’’ Or perhaps they’ll find some sector-beating mutual funds that others will miss.

My friends agree that no one has introduced a better investment idea in the 50 years since this Asset Allocation first became accepted as a state-of-the-art portfolio management tool. Do you really believe that nothing has or could have been developed that works better in all investment markets? Oh, I agree that the Asset Allocation method may work well in long-running bull markets. But, then, so does everything else! Where is the obvious benefit of diversification when every asset class or stock sector is flying?

Yet individual investors and their advisors aren’t the only believers in Asset Allocation. We have been hearing lately that the Pension Benefit Guaranty Corporation finds itself with a current shortfall of nearly $24 billion from failed pension plans, and that shortfall is projected to grow to about $70 billion in 10 years. These failed pension plans were managed by teams of professional investors using the most widely accepted methods for building wealth in the stock market, most noatbly Asset Allocation!

In the past, over 100,000 defined benefit pension plans existed to benefit U.S. workers. Today, about one third of them are still in operation, with many deeply in the red and failing. Could that fact hint at the difficulty professional investors have found the job of producing stated historic returns from stock market investments?

If you are a long-term reader of this column, you know that I firmly believe that the U.S. is experiencing the early stages of a secular, or long-term, bear market. (Anyone doubting this observation can run a computer chart showing the performance of major indices for the past seven years.) In bear markets of any duration, which asset class among small-, mid- or large-cap, growth or value, can be expected to produce positive returns? In bear markets, investors in any of the traditional asset classes eventually tire of swimming against the tide.

Even in bull markets, asset allocation is a losing strategy. But perhaps it’s better than no strategy at all, and that may be why the concept was so readily embraced when first introduced almost 50 years ago. Don’t investors benefit from taking more risks in a bull market? Would any broadly diversified portfolio do as well as a more concentrated allocation in small- or mid-cap stocks?

So does all this mean that investing in stocks is a guaranteed losing proposition? No, it’s just that the most successful investors of our time — or of any time, for that matter — succeed by going their own way. They build unique portfolios that most would view with confusion and trepidation. Today’s endowment fund managers, who are among the best at producing positive returns in any market, practice diversification in this way — the way I seek to employ.

After all, how can an investor be truly diversified when considering only the most commonly held nine asset classes of domestic stocks and adding only small amounts of international, emerging markets and alternative asset classes like commodities? In good times and bad, investors should consider many other asset classes, while holding those only in the early to middle stages of secular bull markets. Thoughtful investors should wonder, as I do now, how any portfolio lacking international bonds, commodities and other hard assets like precious metals and a dollop of bearish positions could ever be considered truly diversified.

The hardest thing for individual investors to do is aim where the target is moving — as opposed to where it has been. Using a method of diversification — like Asset Allocation — that achieves only mediocre returns in bull markets and miserable returns in bear markets seems just plain crazy to this different-thinking advisor.

So here’s a small piece of “different” advice. If your friends think your investment portfolio makes perfect sense, it most likely does not. If the portfolios you own cause your friends to think that you shouldn’t be operating a car or other heavy machinery without supervision, it will probably work well in long-term bull and bear markets. And this bear market is just getting started!

Have a great week,
Bob

8-29

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