Pondering Simplicity In Asset Allocation

"The biggest pitfall [for all investors who decide on an asset mix and invest accordingly] is behavioral, when people don't want to rebalance," Brad McMillan, chief investment officer at Commonwealth Financial Network, tells The Wall Street Journal. What's the solution? The Journal article makes a case for simplicity in asset allocation, perhaps as few as three funds targeting US stocks, foreign stocks, and US bonds.

A minimalist approach has some appeal, but it's hardly risk free. By narrowing the asset allocation down to a handful of broadly diversified funds, the effective bet is that the portfolios will capture most if not all of the necessary risk premia for satisfying your investment objectives. In the grand scheme of what passes for investment advice, favoring this trio of asset classes is a reasonable strategy, particularly if the underlying funds are low-cost index products and the time horizon is at least 10 years.

That said, no investment strategy can be accepted at face value as a silver bullet solution without considering the risks. What are the potential stumbling blocks with limiting the asset allocation to three funds vs. a more granular approach that holds, say, 10 or 15 products? I can think of several, and they're worth considering, if only as an academic exercise.

For starters, let's recognize that whether you hold three or 20 funds, the behavioral challenges of rebalancing are still lurking. That's no trivial issue. Technically speaking, harvesting the rebalancing premium (lower risk, higher return, or both) isn't an especially challenging task. Simple rules can do a lot. If your initial asset allocation has shifted by a considerable degree, for instance, the case for rebalancing is compelling. But the biggest opportunities tend to align with periods when market volatility is relatively high and so it's easy to suffer the deer-in-the-headlight syndrome and sit on your hands.

Given the behavioral headwinds, it's no surprise that relatively few investors (individuals or institutions) manage rebalancing in something close to optimal conditions. The reason is obvious: the contrarian mindset doesn't come naturally to most folks when in matters of financial markets.

You could, of course, eliminate the behavioral/rebalancing issue entirely by holding a multi-asset class portfolio that's managed by someone else. That introduces a different set of issues, which boil down to the well-known complications of picking active managers, albeit in this case an active manager who's skilled at designing and managing asset allocation. Assuming you can find someone of this caliber, and the portfolio matches your investment objectives and risk tolerance, well, mission complete. You're done. But keep in mind that you're exchanging one risk factor (behavioral) for another (choosing active managers).

Otherwise, there's the delicate art of deciding choosing asset classes and managing the mix through time. The Wall Street Journal story suggests that you'll have an easier time if you limit your choices to three asset classes. Maybe, but that's effectively a bet that sidestepping the remaining pieces of the global asset class pie won't hurt the end results. Considering that the major asset classes can be divided into 14 categories, if not more, it's debatable how much risk you're shedding (or holding) with a concentrated approach.

Minds will differ on this decision, but it's best not to blindly accept the idea that less is more without a thorough review of the evidence and some modeling of what's likely to occur. That's hardly the norm. Most folks tend to ignore several pieces of the global asset puzzle out of habit or ignorance.

Even so, you can do quite well if you hold a relatively diversified set of assets and you rebalance intelligently. Over time, the latter is going to be the main driver of portfolio results, for good or ill. Assuming you don't go off the deep end with the initial asset allocation, the lion's share of how your investment strategy fares will be determined by how and when you rebalance. And, yes, that's still true for a three-asset class portfolio.

In other words, don't kid yourself into thinking that if you hold just three funds you'll have an easier time of designing and managing a rebalancing strategy. Market volatility will continue to present you with challenging choices that demand steely discipline to sell when everybody else is buying, and vice versa.

Sure, the task is technically easier with three funds vs. 14. But a relatively concentrated strategy per se is still an active bet relative to the benchmark, or a portfolio that approximates the full opportunity set of risky assets.

Active bets in asset allocation are, to some degree, inevitable, of course. If you had an infinite time horizon, the optimal portfolio would probably be one that holds everything (or as close to everything as reasonably possible) and weights the assets by market value. In the real world, no one has such a time horizon, save for a handful of, say, pension with very long term liabilities. As a result, the crucial issue is one of figuring out how to customize Mr. Market's asset allocation to serve our specific needs.

As such, we face a series of decisions for building portfolios and managing them through time. Choosing asset classes is one of those decisions, and it's an important one. But it's best to see it as part of a continuum of risk-management choices vs. a single get-out-of-jail-free decision. It's tempting to look for simple solutions that absolve us of the messy work that's often required for successful investing. But like everything else in economics and finance, portfolio management is more complicated than it appears.