By FPA member Brian J. Jacobsen, Ph.D., CFA, CFP®
Last Updated: January 18, 2010
The market crisis of 2007 and 2008 shattered many investors' notions of the efficiency and stability of markets. It also likely shattered a lot of investors' confidence in asset allocation schemes. Some investors thought they were following sound strategies, only to have severely adverse results. In my view, the financial crisis of 2007 and 2008 also created a crisis in asset allocation. However, I believe that it was the implementation, and not the essence, of asset allocation that failed.
In my assessment, there are three main lessons from the market crisis of 2007 and 2008:
- Strategic asset allocation is not static asset allocation.
- An awareness of economic and market conditions should inform portfolio allocations.
- Risk management goes beyond "checking the box" of size and style exposure. Other factors, like sectors, countries, and liquidity, also matter.
This is neither the first nor the last time that a market dislocation will occur, which is why it's so important for investors to follow a sound asset allocation strategy to help reduce risk and add value to their portfolios.
It would be easy to demonstrate how strategic asset allocation outperforms a market index, such as the S&P 500, especially after the fact. But the market experience of 2007 and 2008 was so extreme that many investors may have lost all confidence in stocks: The S&P 500 went from a close of 1,561.80 on October 12, 2007 to a close of 676.53 on March 9, 2009. Rather than take a simple approach of showing how asset allocation might have limited losses in such a scenario, I will describe how even qualitative approaches to dynamic asset allocation can benefit investors in a crisis situation and in "normal" conditions as well.
Strategic Asset Allocation is Not Static Asset Allocation
When evaluating the merits of asset allocation, it is important to recognize that not only does the initial allocation matter, but it also matters how — and how often — an investor changes the allocation. The initial allocation can be determined in a number of ways. Some investors use generic heuristic, such as "The percentage allocation to equities should be one hundred minus the investor's age." Others use more "market-oriented" methods by taking the market allocation as the "right" allocation and then making adjustments according to one's tolerance and capacity for risk-taking. Those who are more quantitatively oriented use sophisticated risk-return optimization programs, where a set of portfolios is constructed to have certain risk-return characteristics based on assumptions about the long-run statistical properties of various asset classes. Regardless of which method is taken, I think it is important to stay aware of evolving circumstances and to be aware of the risks a portfolio is exposed to. Ignorance is not bliss, especially when a small investment information can keep someone from abandoning long-term goals.
Considering Human Capital and Financial Capital
An investor's appropriate allocation — amongst cash, equities, and bonds, or however the investment universe is divided — will change with time. One common rule is that as an individual gets older, he or she should allocate more assets to bonds. The rationale is that investors, early in their careers, carry a lot of wealth in the form of human capital, or future income potential. Because work-derived income typically occurs periodically and predictably, much like a bond, as investors approach retirement, their human capital begins to "mature," which could reduce their allocation to bond-like human capital. To keep a constant total allocation to bonds (including bond-like human capital), equity, and cash, as investor's age, they should allocate more of their financial capital to bonds.
From my perspective, I believe this can justify a greater emphasis on active management strategies as an investor ages, as well as a greater emphasis on bonds. Human capital — in the form of income — has option-like qualities. An option is a right, but not an obligation, to engage in an activity. A person can choose to change jobs or to change their retirement date. Options have time decay, in which the value of the option declines rapidly as the option expiration date approaches. Human capital has a similar time-decay: as people age, it becomes more difficult to exercise the option of switching jobs or planning to extend or contract their work life. Instead of viewing human capital as a "bond," I believe that it should be viewed as a "bond plus a bundle of options."
Active management strategies have option-like characteristics because the manager has the choice to invest a portion of the portfolio outside a passive index's investment universe. The manager also has the ability to change the allocation to different portfolio holdings or engage in active trading strategies. These options mimic an investor's options in changing jobs or extending/contracting employment. As investors approach retirement, not only should their allocation to bonds increase, but perhaps their allocation to active management strategies should increase as well. In fact, an allocation to active strategies might substitute well for some of the bond allocation.
Investor-specific information should inform the allocation, especially which securities are included in the investment universe. Conservative investors value predictable cash flows and may therefore prefer bonds, preferred stocks, and dividend paying stocks. Aggressive investors tend to place a greater value on future capital appreciation than on predictable cash flows.
An investor's financial capital should be aggregated with his or her human capital to determine an appropriate allocation strategy. As human capital evolves, to keep a constant total allocation to various sources of risks and returns, the financial capital allocation needs to evolve. Thus, changing human capital — whether it is due to a change of jobs, family changes, health changes, or any other number of things that can impact an individual's human capital — justifies dynamic asset allocation.
Changing Economic and Market Conditions as a Justification for Dynamic Asset Allocation
Investment opportunities change over time. This also justifies a dynamic approach to asset allocation. If markets are not static, then an allocation cannot be static. The relative attractiveness of equities and bonds changes with time and a portolio's allocation should reflect that.
During the financial crisis of 2007 and 2008, corporate yields relative to Treasury yields spiked as the economic downturn intensified. This suggested that investors with a long-term outlook — perhaps without a need for liquidity for the next few years — could purchase debt that was being sold at fire-sale prices. Clearly, the risk was that any given issuer of corporate debt would default, rendering the investment worthless. It was difficult — if not impossible — to ascertain ahead of time which companies would survive and which would fail. This led to the "lemons problem," in which all securities from corporate issuers were lumped together as lemons. The situation provided a good argument for a diversified — as opposed to a concentrated — approach to asset allocation. It could also be used as a justification for investing with fixed-income managers who conduct their own credit analysis instead of simply relying on credit-rating agencies.
A measure of investor myopia, or fear, is the Volatility Index (VIX). The VIX on the S&P 500 is the implied one-month volatility (annualized standard deviation of returns) on the S&P 500. It is calculated from a variety of options on the S&P 500 using a sophisticated option pricing model. Originally, the model was from the famous Black-Scholes option pricing model, but it has since been modified to incorporate more information. This index is sometimes called the "fear index" because its value tends to increase dramatically when investors are looking to purchase insurance (put options) on a portfolio.
Paying attention to various fear or liquidity measures can help identify cyclical opportunities in both fixed-income and equity markets. The assumption is that these measures have long-term tendencies and that short-term deviations create tactical opportunities to reduce risk and add value to a portfolio. The danger is that a supposedly temporary deviation actually signals a structural change in the markets and there is, in fact, no trading opportunity. This is where it is important to understand not only the mechanics of the markets, but also the politics and economics of the time. If there is a regime change, such that empirical tendencies are no longer relevant, being early to recognize the change can create an opportunity to add value through that awareness.
An investor's asset allocation should be dynamically determined, not just as a function of the investor's age, but also as a function of the economic and market environment. Some investors choose a static allocation or stick to a disciplined rule for asset allocation, but I believe there is actionable information contained in economic and market data that can inform tactical shifts in allocations.
The Importance of Time
An important consideration is the investor's investment time-horizon. This will be influenced not only by the investors' ultimate goal, such as retirement, but also by the amount of cash on hand or the ability to meet funding needs. For a person in retirement, a spending account — typically in the form of money market account holdings — is a needed source of funding for immediate and incipient expenses. For someone with other sources of income — for example, a job in which a periodic paycheck is the source of immediate and near-term funding — the same amount of cash in an account may not be necessary, but the source of income is the analog to the retiree's spending account. An investor with a job will also likely want to hold cash balances to account for any possible job loss, but that should be seen as a type of insurance instead of as part of an investment strategy.
For retirees, the amount of cash is often taken as an exogenous variable — sometimes kept at a minimum to keep the investor "fully invested" — but I believe that it is important to manage the proportion of a portfolio held in cash. The cash buffer serves as the measure of the minimum length of time the investor can wait for markets to rebound after a downturn before needing to liquidate equity and fixed-income holdings to replenish the cash account. Investors with additional sources of income can be fully invested and an investor still needs an expectation as to what a typical minimum holding period should be in order to keep from panicking over shorter-term market fluctuations. If an investor has six months of expenses in cash or sources of funding, then that investor needs to be concerned about returns and risks over a six-month horizon. If an investor has one month of cash on hand or sources of funding for only one month of expenses, then that necessitates a focus on shorter-term market fluctuations.
Not only does the amount of cash buffer matter in determining how to measure returns, but so does the frequency of rebalancing. This should all be coordinated and not just approached in an ad hoc way.
Risk management is Not Just about Size and Style
It is not uncommon for asset allocation recommendations for the equity sleeve of a portfolio to focus on exposure to certain market capitalizations or market styles. Such an approach can ignore other important exposures. For example, as of September 30, 2007, value indices tended to be dominated by financial companies, while growth indices were dominated by information technology companies. Focusing on "style exposure" can ignore "sector exposure."
Another common error is over-emphasizing the importance of countries compared to sectors. Up to the end of the 1990s, it was common — and reasonable — to think that country-specific risk was greater than sector-specific risk. In the current era of trade liberalization and capital market integration, however, the notion of home-country is of less significance to investing than in the past. Some of the notions of dividing the world into the United States and "them," are quaint, but not very helpful for asset allocation. True, the United States does retain its status as the bastion of democracy, but its role as the source of economic growth and investment opportunities has declined. The fate of U.S. businesses is not necessarily tied to the health of U.S. consumers, either. In 2008, according to Standard and Poor's, nearly 50% of S&P 500 companies' revenues came from non-U.S. sources. Even the idea of dividing the world into "emerging" and "developed" can be misleading. While countries can be emerging or developed, some of the companies in emerging markets are much larger than developed market companies. There has also been an increasing tendency of emerging and developed markets to move together as they are subject to common global risks.
While country exposure is secondary to sector considerations, it does remain important because of currency risk. A U.S. investor buying stock in a foreign company is not only exposed to the risk of the company, but to the risk of the currency. This risk can be hedged by purchasing future contracts or exchange-traded funds that move inversely with the currency, but it is an additional source of risk that an investor will need to manage.
There are many other risk factors that should be measured and managed, such as political risk, which is especially relevant for international investing. This is one reason I prefer active managers for international investments because managers have the ability to react quickly and — perhaps — preemptively to political developments (e.g., Venezuela nationalizing banks and oil companies). Even in the absence of such dramatic events, businesses operate in an ever-evolving political and regulatory environment. Active managers who can change portfolio compositions quickly are in a better position to respond to developments than an index in which constituents are updated quarterly, yearly, or as needed by a committee.
Conclusion
Asset allocation is in a crisis. However, there are ways investors can use asset allocation to reduce risk and add value to a portfolio throughout a crisis. The key is to not become complacent with your strategic asset allocation.
The basic sources of failure were as follows:
- Confusing static for strategic asset allocation.
- Ignoring the economic and market environment or being paralyzed into inaction.
- Focusing on style and size while ignoring sectors.
True asset allocation is dynamic, it is prospective, and it manages risks that extend beyond simple style and size exposure. These are simple things an investor can do to reduce risk and add value to a portfolio.
FPA member Brian J. Jacobsen, Ph.D., CFA, CFP® is a Capital Markets Strategist with Wells Fargo Funds Management, LLC. The views expressed are as of December 22, 2009 and are those of Dr. Brian Jacobsen, Ph.D., CFA, CFP® and not those of Wells Fargo Funds Management, LLC. The views are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.
Wells Fargo Funds Management, LLC, is a registered investment advisor and a wholly owned subsidiary of Wells Fargo & Company.
A version of this article first appeared in the Journal of Financial Planning.
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