Tuesday, May 07, 2013

On the dangers of micromanging your asset allocation

Why do investors in balanced funds, i.e. those that hold a number of asset classes, hold their funds longer than those investors in more narrowly based funds? The answer is mental accounting. The investors in balanced funds with their lower volatility have fewer periods of negative performance therefore buttressing their ability to hold their funds over the long run.
However the challenge for investors is when they take a deeper peek into their portfolio components. Frequent looks at the portfolio will show some assets going up and some going down. In so doing the temptation, as always, is to dump those assets that are underperforming. Within an overall asset allocation strategy this is counterproductive.
The whole premise of asset allocation is to hold a mix of assets that over an economy cycle provide the highest risk-adjusted returns. By definition this will mean that some assets do better than others. The rise in popularity of the permanent portfolio or the all-weather portfolio since the end of the financial crisis show a desire on the part of investors to have in place an asset allocation strategy for the long run.
James Picerno at the Capital Spectator shows how challenging it is for investors to let their asset allocation strategy run through its paces. He notes the importance of investors to take a ‘holistic approach’ to their portfolios and focus on the bottom line results as opposed to the machinations of the components. Picerno writes:
Many investors aren’t focusing on these issues, in part because they’re too often focused on the pieces at the expense of the whole. But it’s the overall portfolio that defines success or failure, and so to minimize the holistic review is akin to driving with one eye closed. You may be ok, but you’re still courting disaster, and needlessly so.
The whole point of asset allocation is to own assets that perform differently under different scenarios. It might be better to think of this as ‘differsication’ as opposed to diversification. Jason Zweig at Total Return notes that finding true differsication is more difficult that commonly thought. He notes one of the biggest challenges if finding assets that will do well in light of higher inflation.

In an earlier post I wrote skeptically about the idea of all-weather portfolios. In part because at the time I thought they were being oversold as a solution to investor fears. In my book I write that there is no perfect asset class. Nor is there any perfect asset allocation. What I wrotes in an earlier post still holds:
The first is to accept the limitations of asset allocation.  Develop a low cost, well-diversified portfolio of assets with the intent of re-balancing the asset allocation over time.  Provided that this approach includes some risk-free assets, it has the ability of tempering the losses in bear market.  However one need accept that no asset allocation plan can prevent losses in each and every time frame.
It is at times like these when a market, today US equities, is making a huge run when investors most want to flee their previously drawn up plans to dive head long into what is hot. We are admittedly living in unusual financial times, but investors need to recognize that they put their portfolio strategy in place for a reason. Tossing out underperforming assets in this light is usually a mistake and is tantamount to market timing. Investors should try their best to look holistically at their portfolios over time and let their portfolio components do what were enlisted to do in the first place.

Items mentioned above:
Permanent portfolio derivation and historical performance.  (CSS Analytics)
The ‘all weather’ portfolio derivation.  (CSS Analytics)
The whole and the parts.  (Capital Spectator)
‘Differsication’: the sequal.  (Total Return)
The myth of the all-weather portfolio.  (Abnormal Returns)

No comments:

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.