The Common Failure of Asset Allocation

Most investors agree that the biggest decision in investing is asset allocation, but few agree on what the best asset allocation strategy is: from “Stocks for the Long-Run” and “Random Walk Down Wall Street”, to “Endowment Style” and “Risk Parity” to “Factor-Based Investing” and “Dynamic Asset Allocation”.

Why do so many investors fail to achieve the average returns that various asset allocation approaches provide over the long-run? The actual portfolio returns and especially the dollar-weighted returns for most investors (small and large), are significantly lower than the time-weighted averages of the approaches they allocate to. This occurs because investors continuously abandon their previously selected ‘long-term’ asset allocations in response to short-term performance triggers (the main two being crashes and low returns).

Examples of this keep on coming and we don’t need to look far to find them. Prior to 2008, the industry traded in their simple U.S. 60/40 for the Endowment-Style Global 60/40 version with ‘diversifying’ sub-asset classes like International and Emerging Equities (Australia, Japan, Brazil, Russia, India, and China), Commodities (Gold, Oil and Timber), and Real Estate (listed and private). Can you still remember the popular ETF tickers for these sub-asset classes from those days? All of these ‘diversifiers’ were typically added at the peaks of their recent performance (2006-2007), and proceeded to mean revert significantly after.

After the 2008 “Black Swan”, the Global 60/40 was no longer properly ‘diversified’, and the industry shifted to newer approaches. First, it fell in love with ‘properly diversified’ elegant Risk Parity for “all seasons”. By 2011, it was widely adopted, just around its relative performance peak, only to be abandoned in 2017. Then, the ‘hedge fund solution to everything’ kicked in full steam and to everyone’s disappointment it under-delivered. Most recently, the industry has become attracted to a further ‘diversified’ Factor-Based allocation, ‘harvesting premia’, but perhaps has started to question it after the 2018 under-performance.

The irony is that any of these asset allocations over the long-run would have delivered decent results (much better than average and especially dollar-weighted results for most portfolios). And while we can discuss which approach is the best after the fact, the largest improvement to investor returns can come from carefully choosing, refining and sticking with their chosen approach.

One way to achieve this is to stop seeing Asset Allocation as a colorful pie-chart and a ‘back-test’, but instead treat it as a deeply developed professional and personal investment philosophy. Just ‘copying’ someone else’s process because their white-paper looks good is likely to lead to abandonment of this approach during performance triggers (crashes and low returns). Believing Mr. Swensen’s or Mr. Dalio’s or Mr. Buffett’s approach is the one you should use is not a sufficient condition for investors to hold steady during difficult times. On the other hand, equipped with a strong philosophy, Mr. Buffett is not going to abandon value investing just because he is down 50%. He might refine it, learn from mistakes and continue to adapt it, but he will never switch his philosophy all together to, say, a high-frequency or some latest AI approach.

So, in asset allocation, if you are a fundamentally oriented investor and want to understand deeply what you own, then reading David Swensen and then carefully crafting your own version of the Endowment approach for the long-run makes sense. It comes with a requirement to become really good at picking active managers, private investments and deeply understanding the risk and return drivers of various sub-asset classes. It implies occasional, very high, draw-downs that you are committing to withstand, which biologically and emotionally is very hard to do.

If you are a systematic investor at heart and enjoy the calm that a quantitatively driven approach provides by eliminating constant ‘buy and sell’ decisions, then back-tests, factors, and Dynamic Asset Allocation might be yours to explore. The draw-downs appear much better, but now you have to trust your model and resist the urge to override it, especially when returns appear lower than expected for sometime.

If you choose to use an adviser, an outsourced CIO, a consultant, a model provider or a third-party manager, the onus is still on you to make sure you or your client have developed and personalized the investment philosophy before implementing it.

In the end, you don’t have to do better than a 60/40, Dalio, Buffett, Yale or even an average investor - you just have to try to do better than a version of yourself without an investment philosophy, chasing latest trends and switching your approaches at the worst times.

Perhaps the best asset allocation approach is not the one with the highest after the fact average returns, but the one that investors actually stick with for the long-run.

“Even once we are aware of our biases, we must recognize that knowledge does not equal behavior. The solution lies in designing and adopting an investment process that is at least partially robust to behavioral decision-making errors.” – Nassim Taleb