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Radical Thoughts on Asset Allocation

Every so often it can be enlightening to read some contrarian thinking --- particularly about an investment strategy that has so thoroughly pervaded the industry. Fixed, long term (strategic) asset allocation has been standard operating procedure for investment managers for many years. Based on the work of economist Harry Markowitz, it formed the basis of modern portfolio theory. In a nutshell, advisors no longer had to worry about which stocks, bonds or mutual funds were chosen. Simply allocate assets to stocks, bonds and cash based on the investor’s risk tolerance and time horizon and the job is virtually done. Periodically rebalance the portfolio to restore original allocations. This led to the boom in index funds. 

Then theory collided with reality. Rather than spreading money all over the map, clients thought asset allocation should mean concentrating their portfolio in the asset classes that were doing the best and avoiding the asset classes that were in a bear market. So, while everyone embraced asset allocation, advisors and clients had a different take on it. 

Maybe the clients were right!

Is it time to abandon the notion of fixed strategic asset allocation? Some experts think so. The problem is that the studies that supported asset allocation were flawed. And to compound things, the interpretations of those studies were also wrong. Investment opportunities change over time. So asset allocation should be viewed as a dynamic process, i.e. tactical asset allocation. Only if expected returns are fixed should asset allocation weights be fixed. Makes sense. 

A word on tactical asset allocation: Peter Bernstein, who has written 8 well regarded investment books and who at 85 has been called the “dean of investment counselors” said: “We need to throw out the old asset allocation model and become more flexible and ad hoc…” And Mr. Bernstein isn’t the only one. Other credible believers in “tactical asset allocation” include Yale economist Robert Shiller (author of the best seller “Irrational Exuberance”), former Morgan Stanley strategist Barton Biggs and institutional investment advisor Robert Arnott. The latter is a 5 time recipient of the Financial Analysis Journal‘s Graham & Dodd Scroll - considered the Oscar of financial analysis. Their common argument is that in an era of low returns – like the one most forecasters agree is upon us – investors need to be able to tactically allocate assets where the best implied returns exist and the risks are lowest.   

Belmont Financial uses tactical or a flexible asset allocation strategy. Every month, we study economic trends and a perform a detailed review of the risk and return of over 50 world-wide asset classes. In addition to our own analysis, we use data and analysis from top outside providers with long track records. Focusing our efforts on carefully monitoring over 50 world wide asset classes for risk and return, will enable us to quickly identify and act on the next good opportunity. From this analysis, we develop our tactical asset allocation, choosing at least 8-12 of the most attractive world wide asset classes for maximum diversification. Belmont Financial allocates assets only to the most attractive asset classes. 

For example, for many years we had no exposure to US large cap growth.  This made sense given the run up in large cap growth (technology) in the late 90s. Also, when the Fed is raising interest rates, we avoid Treasuries and other interest rate sensitive sectors. 

Then, we select the top performing mutual funds in the most attractive asset classes, again considering risk and return. Fund management tenure and ethics are also factors. There are exceptional fund managers who can add value even if the markets don’t give them a lot to work with. I have enormous confidence in our mutual funds and my disciplined investment process which keeps portfolios invested in the best mutual funds in the best asset classes. The resultant portfolios are extremely efficient, I believe, that is, they combine higher returns with lower risk.

It requires more work, but adds value by keeping portfolios invested in top performing areas of the market. This makes Belmont Financial unique. Many, and perhaps most, advisors employ a fixed, strategic asset allocation. This benefits the advisor – less work, but hurts performance. 

But I am confident that by working hard to make well-reasoned investment decisions and staying disciplined we will be able to generate above-average returns. I expect my rigorous analysis of assets classes and mutual funds to contribute to these returns. We can’t be certain this will be the case over shorter time periods; over longer time periods I am confident this will be the case, although there are no guarantees.

Investment success will require carefully evaluating global asset classes and allocating assets accordingly. The rapidly changing global economy and the creative destruction it brings, make it unlikely we will ever return to the era of “buy a few good companies and hold em”. Furthermore, given all the uncertainty, I believe it is more important than ever to pay attention and develop asset allocation strategies in light of a changing and dynamic global economic environment. There has never been a better time for tactical or flexible asset allocation.