The end of asset allocation

By Felix Salmon
July 13, 2009

It’s a pretty solid rule of investing: good ideas tend to become broadly adopted. And once enough people are all doing the same thing, that thing is probably not a good idea any more but rather a bad idea.

Case in point: asset allocation. John Kay seems to have taken a time-travel machine back to 2006:

The basic principles of asset allocation are diversification and contrarianism. Choose securities with returns poorly correlated to each other.

There are two huge problems with Kay’s prescription. The first is measuring correlation — something which turns out, in practice, to be pretty much impossible. And the second is that correlation measures, by their very nature, are always backwards-looking, and that you can be pretty sure future correlation will be very different from past correlation. What’s more, if there’s a crisis in the future, correlations have a tendency to move to 1.
Tom Lauricella takes the opposite tack from John Kay. Asset allocation, he says, is dead: the crisis killed it. And one of the contributing factors to its demise was one of the very things which Kay extols: the ETF. Kay loves ETFs, because they have low fees. But when investors piled into commodity ETFs over the past few years, in the name of diversification, all they really did was massively increase correlations between commodities and other asset classes. As a result, when stocks tumbled, so did commodities:

At Pimco, the firm’s head of analytics, Vineer Bhansali, points to commodities as an example of how diversification strategies can break down. Even as stocks and bonds struggled in early 2008, commodity prices were in the midst of a historic rally. Wall Street rolled out research showing the lack of correlation between stocks and commodities.

But that history didn’t take an important point into consideration. Prior to this decade, investing in commodities was a complicated process due to the complexity of the futures markets. The advent of exchange-traded mutual funds, or ETFs, allowed investors to buy and sell commodities with the click of a mouse. By the summer of 2008, ETF investors had poured billions into commodities in just a few months.

As the financial crisis worsened and stock and bond prices collapsed, ETF investors who needed to raise money found it easy to bail out of commodities, too. That contributed to a 37% drop for 2008 in the Dow Jones AIG Commodities Index.

“When people start buying an asset, the act of them diversifying ultimately makes the asset less of a diversifier,” says Pimco’s Mr. Bhansali.

Rick Bookstaber has dozens of examples along these lines, many of them much less obvious than the link between stocks and commodities. The fact is that if you think you’re invested in an asset class which will zig when the rest of your portfolio zags, you’re probably wrong. Look at the performance of so-called “market-neutral” hedge funds: they all went up in the up market, and they pretty much all went down in the down market. If super-sophisticated hedge-fund managers can’t get correlation right, there’s probably no point in the rest of us even trying.

Ultimately, I suspect that any investment strategy more sophisticated than “buy low, sell high” is doomed to fail eventually. If a certain strategy worked for your grandparents, that’s probably a good reason that it won’t work for you. (And yes, Warren Buffett counts as Gramps for these purposes.) In investing, nothing lasts forever. And the era of asset allocation is in its waning years. The problem, of course, is that no one has a clue what might replace it.


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You wrote a whole entry on asset allocation without using the word “risk” even once.

Posted by Sterling | Report as abusive

Quant market neutral is just lazy market neutral.

The fact that algorithm-based strategies are dumb is no case against market neutral.

Some of us do real market neutral (in the spirit of Alfred Winslow Jones) and have made good money over the last ten years.

All the rest is junk.

Thus this article is either lazy or junk.

Your choice

Strategic asset allocation is the worst way to invest except for all the others. Those who piled into commodities in the pre-2008 period justified the move with the diversification argument but most were just chasing the hottest asset class (a time-honored investing mistake which strategic asset allocation mitigates).
Not all correlations went to 1– eg, 30y Treasuries or VIX futures did very nicely. The problem was that most investors held many different-looking asset classes that were all biased to perform well in environments of strong economic growth, low volatility, stable liquidity premiums, etc. The commodities probably would have been helpful if we’d suffered an inflation shock, but we suffered a very different type of shock. So it was not unreasonable to expect correlations of many of these asset classes to rise in this type of crisis.
I’m not suggesting building an asset allocation to protect against last year’s crisis, just that a truly diversified portfolio (with protection against slumping growth and spiking liquidity premiums in addition to runaway inflation, a run on the USD, and other disaster scenarios that we have experienced or may yet experience) will do better in the long run than flying by the seat of your pants (unless of course you are a brilliant timer of markets which most of us are not). SAA will not be a panacea–you will still mostly likely lose money in scenarios where risky assets sell off. But if done correctly diversification should provide some cushion in these disaster scenarios and at least prevent an investor from bailing at the worst possible moment (which many investors did in Q1 2009, proclaiming that strategic asset allocation was dead).

Posted by Papito | Report as abusive

To an extent, asset allocation schemes suffer from the same flaws as the conglomerate madness: the idea that your divisions would be both counter-cyclical relative to each other AND would still produce good returns proved largely a wrong idea.

Posted by jonathan | Report as abusive

Perhaps every reasonable investment strategy works well some of the time, depending on market conditions. The only problem is that market conditions change unpredictably. And any investment strategy that is currently working well can suddenly turn into a money loosing operation.

Perhaps the only investment strategy that works well in the long run is one that is based on fundamentals of the economy and the company.

The stock market is unpredictable in the near term. But eventually the stock market does respond to real economic conditions and company profits. Investors can ignore the reality only for so long before the reality becomes so real that they can’t ignore it anymore.

But being right in the long run requires a lot of patience. Investors are perfectly capable of ignoring the reality for a few years, as it happened during the tech mania and the housing boom that followed it.

Posted by Nick | Report as abusive

Great post. I’ve been wondering about this for a while and this is the first time I’ve seen anyone bring it up.

I think it’s to Felix’s credit that he didn’t use the word risk. “Risk” in the context of asset allocation means treating past performance and past correlations as if they could predict the future. They can’t. Okay, maybe a little bit, but not nearly as much as people claim. It’s hilarious how people rationalize around this — “We have data going back to 1801″ (or 1906 or 1927) as if that’s relevant to today. You might as well factor in yields on 14th century Venetian bonds. Or the other extreme, “Sure, the asset class was only created in 2002, but five years is enough data to make the mean-variance optimizer spit out some numbers!”

It comes down to being able to tell the difference between a law (e.g., carbon has six protons) and mere trends. I have no doubt that asset allocation will work again sometime soon, and will continue to work, until it doesn’t.

With policies favoring (1) extremely high leverage and (2) the long time horizon of 401K investors, we have created a world in which there are effectively only two distinct asset classes: cash and everything else. In other words, there are no opportunities for diversification in the current environment.

Posted by maynardGkeynes | Report as abusive

The WSJ article concludes that PIMCO discovered that equities & TIPs gives you good diversification. They’re calling themselves asset allocators and they just figured that out?

The article also claims “The theory of asset allocation emerged in the 1950s when economists such as Harry Markowitz, who would later win a Nobel Prize for his work, developed mathematical models for ways to improve investment portfolios.”

However Jacob Fugger was allocating 25% each to Stocks, Bonds, Commodities, Cash during the Renaissance. 1459-1525-Biographies/dp/1587981092

Posted by VennData | Report as abusive

Asset allocation is both an outcome and a process. Whatever alternate strategy one uses, you always end up with some asset allocation. Felix suggest that estimating future correlations is difficult. I agree. But estimating future returns is also difficult and standard mean-variance optimization is far more sensitive to errors in return prediction than covariance prediction. But we would still take a tab at it and use intelligent approaches like Black-Litterman to sort some of these problems out.

The point is that once you develop an investment strategy (whatever approach you use) you end up with an asset allocation and and that asset allocation “implies” an estimate of returns, variance and covariance. You cant get around it. The question is do you pay attention to those or not.

Posted by AY | Report as abusive

“We are in a period of forced liquidation, which has happened only eight or nine times in the past 150 years. The fact that it’s historic doesn’t make it any more fun, of course. But it is a pretty interesting time when there is forced selling of everything with no regard for facts or fundamentals at all. Historically, the way you make money in times like these is that you find things where the fundamentals are unimpaired. The fundamentals of GM are impaired. The fundamentals of Citigroup are impaired.”

I agree with Jim Rogers. We have been in a slow motion bout of Debt-Deflation. In such an environment, most assets lose value, at least until Debt-Deflation ends. That’s one reason that Debt-Deflation is so disorienting: It’s hard to read the fundamentals in such a situation.

But, when it ends, Kay’s points will still be useful, and, more importantly,understandable:

“In defying fashion, the retail investor potentially has an advantage over the professional. Professionals are judged by their relative performance. But relative performance does not pay bills. You can take a more detached view, and you should.

Most investors will, and should, begin with funds rather than individual stocks. ETFs are a good place to start. Plan to build up a portfolio of such funds, emphasising sectors that are out of favour.

Then consider an allocation to actively-managed funds. Pick two or three idiosyncratic funds with widely different styles and approaches: this gives a better balance of risk and return. But keep a close eye on charges. A company that charges 1 per cent or more for a closet index fund is ripping you off. Buying a closed-end fund with a low TER and a large discount to asset value keeps down the effect of charges.

Three simple rules – pay less, diversify more, and be contrarian – will serve almost everyone well. Financial markets are complex, but much of the complexity is for the benefit of providers rather than consumers.

If you don’t understand it, don’t do it. That simple maxim would have saved amateurs and professionals alike billions of pounds in recent years.”

Your position would seem to imply an upcoming era of financial convulsions. If that occurs, it will be hard for anyone to figure out exactly what to do. I’m not advocating any investment strategy, but it should be at least as simple and easy to understand as Kay’s post is. I would suggest that the era of complexity should be over, but I know better.

[ If a certain strategy worked for your grandparents, that’s probably a good reason that it won’t work for you. (And yes, Warren Buffett counts as Gramps for these purposes.)]

surely that would make Benjamin Graham “Great-Gramps”?

Posted by dsquared | Report as abusive

re: pimco discovered equities give you good diversification

July 1 (Bloomberg) — Bill Miller’s Legg Mason Opportunity Trust was the biggest-gaining U.S. stock mutual fund in the second quarter, surging 48 percent… Pimco Extended Duration Fund… was the worst-performing bond fund, Morningstar said. The fund, with $199 million in assets, dropped 13 percent. The world’s biggest bond fund, the $156.9 billion Pimco Total Return Fund, managed by Bill Gross, gained 4.9 percent… 0601213&sid=aaVrWcFFPxHs

Posted by ac | Report as abusive

investment replaced by HFT

“…trading strategies that are based not on… fundamentals, but on arbitraging minute differences in share prices and trading speeds… “electronic liquidity providers”, represent about 2 per cent of the 20,000 or so trading firms operating in the US markets. But they accounted for 73 per cent of all US equity trading volume…” 11de-8b19-00144feabdc0.html

Posted by ac | Report as abusive

I observed a long time ago that the great traders are not mathematicians. Their subjective views are far more powerful than all the rigorous historical correlation analysis.

Posted by Steve Numero Uno | Report as abusive

read Faber’s paper in the Journal of Wealth Management for a simple solution, free on the SSRN: bstract_id=962461

Posted by Kris Kross | Report as abusive

“And the era of asset allocation is in its waning years. The problem, of course, is that no one has a clue what might replace it.”

Asset allocation has never been more relevant. Stocks and real estate have had a rotten decade. Commodities, commodity stocks and longer government bonds meanwhile have had a great decade. Short term money and emerging markets were a wash. In 2008, stocks were horrifically bad while government bonds and cash were terrific.

Posted by Dan | Report as abusive

The end of asset allocation? That, my friend, is probably the dumbest statement I’ve read over the last 12 months. Nothing personal, but it doesn’t even make sense. Can’t measure correlations? Do WHAT?

Posted by Bill Bowers | Report as abusive