The Third Pig

The following commmentary is an excerpt from Brick Financial Management's February 2006 client letter:
"...The Zealot answer to the problem would be to create a portfolio set with some fixed percentage in stocks, some in bonds and some in cash without regard for valuation. This would be executed through some investment combination in index and actively managed mutual funds. The practice commonly referred to as asset allocation (or the Investment Policy decision), thought by the Zealots to be the most important decision an investor can make. The Zealot believes that the asset allocation decision, and not security selection, is the most important determinant of long term performance.

The Zealots and asset allocation As proof they reference one (that’s right, one) study. We’ll call the study BHB. The Zealots tell us that BHB says that of the determinants of performance - asset class selection, security selection and market timing – asset selection determines 93.6% of long term portfolio performance. [We find it odd that BHB did not consider management fees, transaction costs and taxes among the determinants.] They also went on to say that security selection determined less than 5% of portfolio performance. The Zealots love BHB as it seems to support EMH which states that security selection is pointless.

Variation in returns is not total returns But we (the Heretics), being skeptical by nature and being unable to ignore the success we’ve had with security selection, didn’t buy the interpretation of the BHB study. So we actually read the thing. What did we discover? At no point does the BHB study measure total long-term returns. What it measures is the total variation in quarterly (short-term) returns. In other words, BHB measured how much a portfolio went up and down over short periods and not how much money it made in the long term. BHB determined the successful portfolio as one that didn’t fluctuate a lot. Whether or not the portfolio actually made any money was not a determinant of investing success. Hmm…interesting.

Variation in returns means little We must keep in mind that the variation of quarterly returns alone tells us practically nothing about the prospects of investors achieving their financial objectives. Funding financial objectives comes from portfolio contributions and the compounding of returns over time. In other words, returns should not be ignored, even in the short-term. [Further, even if short term volatility is of utmost concern, we must realize that extreme diversification does not necessarily eliminate it. A more effective technique would be to choose investments that havesimilar returns but do not move in tandem. In other words, they should have a high negative correlation.]

Traditional asset allocation fails When using the material in the BHB study, and interpreting the results correctly, we find that the asset allocation decision determines only 15 percent of returns over a 10-year period. This little tidbit damages the credibility of the asset allocation process as practiced today, which is to say that long term investors should automatically be invested mostly in stocks and short term investors should automatically be invested in bonds and cash. This portfolio management by autopilot is nonsense. In our Client Education Brochure, we point out thatover 10-year periods, stocks perform better than bonds and cash over 80% of the time. But turned on its head, we see that bonds and cash perform better than stocks 20% of the time. If your time horizon is only 10-years long, wouldn’t you want to know which assets would perform best over the coming period? What you wouldn’t want to do is make an assumption that history will repeat itself. We think it important that we account for those times when stocks underperform.

Using, better yet, misusing the BHB study the Zealots set portfolios with rigidity (i.e., 20% large cap stocks, 10% foreign stocks, 15% small cap stocks, 10% short term bonds, etc). They wind up owning stocks from every corner of the market. Should any one piece of the portfolio advance or decline too significantly away from the original asset allocation, Zealots either buy or sell accordingly. This would seem to make sense if it were not for differing time horizons, valuation and costs.

As we just mentioned, there are occasions when both bonds and cash perform better than stocks, usually during extended bear markets. Thus the problem arises when arbitrarily selling (or buying) a portion of a portfolio that has advanced (or declined) significantly. The problem is exaggerated when valuations of the securities and the time horizon suggest just the opposite action should be taken. Extreme diversification, as traditional asset allocation requires, would always have the client in some asset that was underperforming. At best theportfolio would do about average with the market. As Heretics we can’t shake the belief that we should try and can do better than the market.

Value allocation succeeds Brick Financial believes that most investors should have some exposure to stocks, bought at low valuations, at all times. But when we create portfolios we will let the valuations of groups of stocks, bonds and cash, determine the asset allocation. This process is sometimes called “Tactical Asset Allocation”(TAA). A more fitting title would be “Value Allocation” (VA) which accounts for valuation of securities, investment time horizon, costs and fees..."

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