August 28, 2009
In addition to the question of how many stocks they should own, another similar question many investors ask is how many funds or asset classes they should own. In a recent Financial Times column, David Stevenson offers some interesting data on the topic, as well as some comments from top strategists.
The “proper answer” to those questions, Stevenson says, is to follow the modern portfolio theory developed by Harry Markowitz, which “suggests that you look at risks and returns, alongside volatility, and then compute something called ‘an efficient frontier’ of different assets, allocated sensibly, in an optimised fashion.” But, he adds, many of the top financial minds in the world — including Markowitz himself — don’t do that. Markowitz actually once said that he regretfully split his portfolio 50/50 between bonds and equities.
“He’s not alone,” Stevenson continues
Modern risk analysis founder William Sharpe, for example, has said simply that he invests in large stocks, small stocks and international stocks.
So is there empirical data on how many funds or asset classes is enough? Stevenson says two studies, one performed by U.K. financial planner James Norton and the other by U.S. strategists Paul Merriman and Richard Buck, found that eight or nine funds provide the best risk-adjusted returns. Norton “started with a classic 60/40 split (Citi Bond index and FTSE all Share) which produced an average annualised return of 8.83 per cent a year with volatility (standard deviation) of 9.58 per cent,” Stevenson writes. “He then progressively added funds until he got to eight (FTSE All Share, MSCI World index exc UK, emerging markets, value and small cap for both the UK and the World), which produced a higher annual return – 9.91 per cent – but with almost exactly the same volatility: 9.69 per cent.”
Others think that’s too high. “Most of the advantage of diversifying happens with three or four significant positions in seriously cheap assets,” strategist Rob Arnott said. “If you go beyond ten, you’re deluding the opportunity set. You’re reducing your ability to add value.“
Tim Bond of Barclays Capital, meanwhile, says overdiversifying can be very dangerous if the best opportunities are in special, smaller areas of the market — as he says is happening now with China’s infrastructure boom and the new carbon lite economy. In such instances, diversification is “literally the worse possible solution to your investment needs,” he said.
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Randy Swan of Swan Consulting, Inc. says, “…the great claim of asset allocation relates to the risk reduction achieved by diversifying over several broad asset classes (i.e. stocks, bonds, cash and real estate) without a similar reduction in return. However, the risk reduction is strictly theoretical (typically based upon relationships that existed over a particular period with no guarantee that these same relationships will continue in the future). This is the crux of where asset allocation or modern portfolio theory breaks down. Risk is not defined; instead it is merely expressed in historical standards.” And, “…stock with a reasonable amount of protection and income generating opportunities are you only real bet…”
All asset classes with similar correlations are in effect one class. Therefore, the classic equity diversification of: Lg Cap, Mid Cap, Sm Cap and Internationa is, in reality, only ONE class. Some diversification.
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Asset allocation does work during bull markets but FAILS miserably during bear markets. It fails because the Markowitz Modern Portfolio Theory (MPT) is a buy and hold strategy over the long term during good markets and bad.
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If you doubt that it fails just look at the last 9 years and consider the potential future gains (or lack thereof) over the anticipated long “L” (5-8 years) recovery period we are facing as markets rise and fall, like Japan’s did in the 1990’s.
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Since Markowitz doesn’t believe market returns for timing are material, how long is long term for current retirees vs. those in their 30’s? Without market timing, retirees are going to get screwed, blued and tattooed.
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Even though commodities have low correlation to equity they can’t be added to an MPT portfolio since they trade in a sine wave over the long term with extreme volatility and no inherent, non-inflationary growth path. Oil may be a growth path exception on a going forward basis given Peak Oil projections but it will not be a volatility exception.
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PIMCO and some others have published their versions of a low correlated Asset Allocation. These too all recently got slaughtered.
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If the Nobel Lauriats, investment companies and other market gurus of the world can’t build a successful Asset Allocation, NOONE can.
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Therefore, Asset Allocation is a fantacy, a fairy tale, a hoax that has been perpetrated on the gullible by charlatans, well meaning dupes and financial advisors.
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Financial advisors love Asset Allocation. In my opinion, Asset Allocation is a mindless, low maintenance and low cost (low ticket charge) way for extracting fees from clients for selling a not very creative mix of mutual funds.
You can’t develop an effective strategy for protecting yourself against risk unless you clearly define the risk you’re aiming to protect against. There are actually seven types of risks and each requires a different strategy:
1. Economic risk – results from the periodic slowdown that the general economic goes through. Past economic slowdowns have come from the need for industry to adjust inventories, from a slowdown in housing or from external causes such as the oil embargo of the 1970’s. Economic slowdowns usually cause the stock market to correct or retreat.
2. Foreign exchange risk – there are ramifications, some positive and others negative, whenever the $US losses standing in foreign exchange markets. Companies with large foreign-based revenues and income benefit while U.S. consumers and importers suffer. The greatest adverse impact from $US exchange rate weakness is in the cost of mostly imported oil and energy costs.
3. Interest rate risk – when rates increase for whatever reason, stocks become less competitive with the less risky fixed income investment alternatives and therefore suffer in price declines.
4. Market risk – stock prices, after extended runs, required often consolidate extended gains to allow reality to catch up to the market valuations. At the extreme, being partially driven by momentum and sentiment, markets can become irrationally high with trading resembling classic market “bubbles”. The excesses have to eventually be wrung out of market valuations through major downside adjustments.
5. Industry risk – single industries may face common adjustments brought on by government regulation, technological change, foreign competition, weather or supply shortages. The stocks of all industry competitors will be adjusted in tandem.
6. Specific company risk – individual companies may face unique risks from mismanagement or poor execution, top management defection, competitive weakness or poor product design or performance.
A wide range of stocks works best against specific company and industry risks. The only “diversification” strategy that works best to protect against the other 4 types of risks is market timing.