by Michael E. Kitces, CFP®, CLU, ChFC, and Kenneth R. Solow, CFP®, CLU, ChFC
Michael Kitces, CFP®, CLU, ChFC, is the director of
research for Pinnacle Advisory Group (http://www.pinnacleadvisory.com/)
in Columbia, Maryland, and the publisher of The Kitces Report
through his Web site, http://www.kitces.com/.
Kenneth R. Solow, CFP®, CLU, ChFC, is the chief investment officer and a founding partner of Pinnacle Advisory Group and author of Buy and Hold Is Dead (Again).
Markowitz's Modern Portfolio Theory (MPT) and Sharpe's Capital
Asset Pricing Model (CAPM) are taught to virtually all financial
planners, financial analysts, and MBAs as the fundamental
methodology for portfolio construction. While these theories have
provided important groundwork for the growth of the money
management industry, many academics today have recognized that the
mathematical and economic assumptions in these models are
questionable; they do not clearly meet the test of "real world"
observations about market or investor behavior. This leads to the
next natural question of whether better investment approaches can
be utilized based on advances in economic and markets theory,
behavioral finance, and newer, more complex approaches to
mathematically measuring risk.
Rational Expectations Equilibrium Theory
Interestingly enough, both MPT and CAPM are based on an economic pricing model called the Rational Expectations Equilibrium Theory. Two of the main assumptions underlying this model are that economic agents (anyone who is part of the economy) have perfect economic foresight-they can predict changing trends in the economy, and can perfectly foretell what future prices will be as a result of those changes-and that the only changes that affect the economy come from "outside" the economic system. Fires, floods, famine, or news-called exogenous events by academics-can be considered outside changes to the economy that will affect prices.
The theory further says that even in the face of such unpredictable events, investors can still perfectly adjust their evaluation of how prices will change as a result of these events. The behavior of investors themselves is presumed to have no effect on price changes, a somewhat disturbing assumption in light of the many investment bubbles that we have experienced over the past decade.
Finally, the economy is assumed to be stationary, which means that events like global warming, the aging of the baby boomers, and the fall of the Berlin Wall and the end of the Cold War are presumed to have no effect on the economy.
In a world where Rational Expectations Equilibrium Theory is true, and markets are therefore perfectly efficient, one may reasonably assume that the best way to "forecast" the future is simply to assume that it will continue to produce its stationary-derived economic results; in other words, that long-term historical averages can be an accurate forecast of future investment returns. This assumption in turn leads investors to believe that there is only one fixed asset allocation that is most efficient for their given level of risk and return (or alternatively, that there is only one efficient frontier that can be derived, based solely on those long-term historical returns).
Perfect Economic Foresight?
Unfortunately, though, time and again investors have proven that they do not have perfect economic foresight or the ability to perfectly identify future prices based on changing economic trends. In fact, anyone who remembers the late 1990s will recall how large numbers of investors gladly participated in a mania of buying technology stocks. They were so convinced that the world was on the cusp of a new economic order that they were willing to pay any price for these stocks and rationalize the purchase in ways that, in retrospect, seem almost silly, but at the time seemed appropriate. In other words, investors don't seem to really know what future prices will be (that is, they do not have perfect economic foresight), and instead appear to routinely make mistakes about future pricing.
In addition, the economy does not truly appear to exhibit stationarity. Events such as global warming, changing age demographics, and structural shifts in the economy do happen. Further, market volatility does not appear to be solely a function of external news events. As the repeated bubbles and manias of the past decade have made clear, there is another type of risk out there-endogenous risk, or the potential for markets to move based not on external news events, but because of the behavior of the market participants themselves (for example, moving as a herd and creating irrational bubbles). Investor perceptions about information technology, the age-wave, global warming, the emergence of global markets, biotechnology, and many other ongoing change agents will have a major effect on the economy and on the future behavior of financial markets as investors try, imperfectly, to predict future prices and invest accordingly. This inherently creates the opportunity for some investors to be more accurate and make fewer mistakes than others in their predictions, thereby earning greater investment returns as the rest of the market participants adjusts their own not-quite-correct predictions in the face of subsequent actual events.
Tactical Asset Allocation
In a world that doesn't change, traditional portfolio construction will serve investors just fine. Because investors are presumed to be rational and have perfect economic foresight, and because there is no change believed to occur in the economic system, investors can safely assume that past returns will be repeated in the future. In this world, asset class returns, volatility, and the correlation of returns for all asset classes can be modeled using traditional techniques, and the investment adviser's role is simply to provide a fixed diversified portfolio that lies somewhere along the single fixed efficient frontier.
Once this set of assumptions about the perfect efficiency of the market is rejected, however, the world of portfolio construction shifts to one that is tactical. Instead of assuming that the future can best be forecast with long-term historical averages, the future must instead be forecast more dynamically, and the investor must tactically change the portfolio asset allocation in response. As soon as you allow for the possibility that the data can change, the possibility exists for multiple efficient frontiers-it just depends on which forecast is used.
Furthermore, if the future is presumed to be uncertain, then investors may believe that different efficient frontiers are truly optimal; in practice, we won't know which was really best until after the fact, when we see what uncertain investment results actually occur. Those who can forecast better than others and make fewer mistakes in tactically investing that forecast will find their efficient frontiers and asset allocation recommendations to be more effective than those of others.
Be Flexible; Make Incremental Changes
At its core, the fundamental principle of tactical asset allocation is to be flexible and prepared to make changes in the portfolio construction based on the changing realities and the investor's perceptions of the financial markets. Such changes do not need to be drastic; instead, they are more likely to be incremental in nature, reflecting the incremental addition of new information and updated forecasts about the future. These incremental changes allow the investor to gradually change the risk-reward characteristics of the portfolio over time, through a full economic and market cycle, over a shorter- to intermediate-term (i.e., tactical) time horizon.
In practice, recent survey data appear to suggest that many planners have already rejected the idea that markets are efficient, and have started down the road of tactical asset allocation in some manner or another.
As a relatively new approach for overall portfolio management, there is still much to learn about how to evaluate economic and market cycles, how to make forecasts, and how to tactically invest those forecasts. Those who adapt and learn more quickly have the potential to achieve better results for their clients than those who do not. Alternatively, for those who do not wish to learn the art of tactical asset allocation for themselves, a decision to outsource the investment management process may be preferable. Nonetheless, the trend toward tactical asset allocation-whether by an internal or outsourced approach-is already under way.
Sidebars
Defining Tactical Asset Allocation
Tactical asset allocation: An active management strategy of rebalancing the percentage of assets held in various categories in a portfolio to take advantage of market pricing anomalies or strong market sectors.
I agree with this definition of tactical asset allocation: 76%
I disagree with this definition of tactical asset allocation: 17%
Don't know/not applicable: 7%
Most Advisers Using Tactical Asset Allocation
Do you use tactical asset allocation in managing your clients' portfolios?
Yes 45%
No 30%
Sometimes 25%
Active vs. Passive
In general, which type of management do you think provides the best overall investment performance taking into account costs associated with each management style?
Active
65%
Passive
35%
Source: FPA's 2010 Trends in Investing survey
Editor's Note
This article is part of a Trends in Investing Special
Report from the June 2010 Journal of Financial Planning. For
complete coverage of the Special Report, visit www.FPAjournal.org/CurrentIssue/Supplements
.
