Dynamic Asset Allocation Beats Buy-and-hold
Asset Allocation Is The Biggest Decision An Investor Makes
. Most investors spend the vast majority of their time and effort on two aspects of investing: choosing which securities to buy and choosing which fund managers to hire. Wall Street brokers, web sites, newsletters, books and talk shows endlessly parade the next sure-fire way to pick the best stocks. And then there are the fund managers. There are now more managed funds hedge funds, mutual funds, pension funds etc. - that own U.S. stocks than there are stocks. An industry has even developed to help investors pick money managers by rating them based on past performance.Investors are wasting their time and effort. Another aspect of investing is far more important in determining investors returns: asset allocation. Asset allocation refers to the percentage of assets in an account (or an entire portfolio) devoted to different asset types. Most securities brokerage accounts and fund-based accounts, like a 401(k) or mutual fund account, offer just three basic asset classes: stocks, bonds, and cash.
In determining investment returns, asset allocation is FAR more important than the individual securities or the investment manager the investor chooses. Studies of investment returns over the long term suggest that asset allocation is responsible for about 90% of returns while manager/security selection is responsible for about 10%. Deciding how to allocate savings among stocks, bonds and cash, therefore, is the biggest decision an investor makes.
Static Asset Allocation Buy and Hold. Prevailing investment theory recognizes the importance of asset allocation, and teaches that investors should pick an asset allocation and stick with it as long as their investment goals remain unchanged, regardless of the performance of or outlook for the asset classes in which they are investing. This strategy, commonly called buy and hold, advises investors to maintain a static asset allocation for very long time periods.
How does an investor choose an asset allocation for the buy and hold strategy in the first place? This critical decision that will determine the outcome of a lifetime of investing is usually made in about 30 minutes after the investor determines his time horizon and risk tolerance. Time horizon simply refers to the amount of time until the investor needs to convert the investment into cash. A 30-year old saving for retirement has a long time horizon, while someone investing for their 17 year-old daughters college education has a short time horizon.
Time horizon is important because the buy-and-hold theory assumes financial markets, particularly the stock market, are highly unpredictable in the short term but very predictable in the long term. In the long term, the stock market has earned far greater investment returns than the other asset classes, so investors with long time horizons are typically advised to devote large portions of their investment portfolios to stocks and ignore any losses that may occur in the short term. Investors with a shorter time horizon usually are advised to avoid the stock market because large (unpredictable) losses frequently occur in the stock asset class, while losses are much rarer in bonds and cash.
Risk tolerance is the other reason investors are advised not to devote all of their savings to stocks. The concept of risk tolerance recognizes that some investors will be uncomfortable with a portfolio made up largely of stocks because of the wide swings in value that can and do occur in the stock market. A portfolio that balances stocks with the less volatile bonds and cash asset classes should experience smaller and less frequent losses than a portfolio of all stocks. The lower the risk tolerance, the smaller the percentage of the portfolio that should be devoted to stocks.
Unfortunately, the static asset allocation or buy-and-hold approach has failed a generation of investors. Most investors who have adhered to a typical static asset allocation approach have endured terrible investment results for more than a decade because of the dismal returns of the U.S. stock market. But more importantly, what the static asset allocation approach fails to take into account is that investors goals and risk tolerance are NOT static. Instead, investors tend to become far more conservative (concerned about losses) after losses in the markets and far more aggressive (concerned about missing out on gains) after significant gains.
For this reason, most investors make poor asset allocation decisions. For example, a recent study of 401(k) plans from 1988 2007 found that the stocks asset class returned 11.81% annually, investment grade bonds returned 7.56% per year, and Treasury bills (cash) returned 4.53%. What did the actual 401(k) participants earn? They earned 4.48% annually, less than they would have earned had they invested 100% of their retirement savings in T-bills. This result was not due to poor performance of the funds within 401(k) accounts (although that was a factor), it was because investors bought and sold equity funds at the worst possible times they bought high, sold low and managed to miss out on one of the best 20-year periods in U.S. stock market history. It hardly matters if a strategy is sound if investors are unable or unwilling to follow it. The results are clear
It is time for a new approach to asset allocation.
Adopt A Dynamic Asset Allocation Strategy. While the term dynamic asset allocation is often associated with hedge funds using rapid-trading computer models, in its simplest context, dynamic asset allocation means an asset allocation that changes in response to market conditions, the opposite of remaining static. In order to maximize profit, the ideal asset allocation strategy would be to own stocks when they are earning superior returns, but sell stocks and invest in cash or bonds during significant stock market declines.
Traditional financial teaching says this strategy is impossible to execute in practice. Investors cant possibly know when stocks will earn their superior returns if all investors knew when stocks were going to go up, who would sell them stock when it was time to buy? And far too many random events occur to make accurate price forecasting possible. The efficient market theory teaches that market prices are effectively random in the short term and cannot be predicted with any accuracy.
But if stock market prices are effectively random in the short term, how can the efficient market theory explain the performance of the 401(k) investors studied above? Those investors managed to predict the stock market in the short term with amazing accuracy. Granted, their investment results indicate that they were consistently wrong about the markets future direction, especially at the most critical times, but that consistency cannot possibly be explained by randomness (indeed, 401(k) investors would be better off with a randomly selected asset allocation). Thus, this is just one way the stock market is not random or efficient: when a significant majority of 401(k) investors is expecting one thing in the stock market, the opposite usually occurs.
This is just one of many types of data that predict the future movements of stock prices, with varying degrees of accuracy (no data is 100% accurate). Any data from the behavior of 401(k) investors to the weather in New York City can be compared to stock price returns to determine its predictive value. By analyzing the data that best predicts stock price returns, investors can employ a dynamic asset allocation strategy to vastly improve investment returns. For example, if the current predictive data indicates that stock prices soon suffered a big decline 90% of the time the data previously occurred, shouldnt investors sell most or all of their stocks? Or should they buy and hope that its different this time? Instead of devoting a fixed allocation of a portfolio to stocks, investors should establish a minimum and maximum percentage of their portfolio to be devoted to stocks. A more conservative investor, for example, might choose a minimum of 0% and a maximum of 60% of her portfolio for stocks.
While continually tracking the data that affects stock prices and other financial markets can be a time consuming task, every week the DAGMA Market Update summarizes the current state of the data that has historically predicted future stock price movements and recommends when asset allocations should be changed. Choosing the percentage of a portfolio to devote to stocks within a range is as simple as following the DAGMA Stock Market Outlook. When the Stock Market Outlook is Bullish or Extremely Bullish, investors should be near or at their maximum asset allocation to stocks (60% in the example above, or $60,000 out of a $100,000 portfolio). When the outlook is Bearish or Extremely Bearish, investors should be at or near their minimum, and somewhere in between during Neutral times.
By using a dynamic asset allocation strategy instead of devoting a static portion of the portfolio to stocks at all times, investors can actively reduce their risk of losses in the stock market. And by reducing exposure to stocks at various times, investors have cash available to reinvest in stocks if and when prices fall. Most importantly, by employing the dynamic asset allocation strategy and observing the factors that actually drive stock price change, investors will quickly learn to avoid the common mistakes most investors make. DAGMA subscribers often learn that investing in stocks is both easier and more difficult than it appears easier because price change is surprisingly simple to predict with a high degree of accuracy; more difficult because the right decisions usually feel like the wrong thing to do. Ultimately, engaged and educated investors are less troubled about unpredictable changes in financial markets and have a better chance of reaching their financial goals.
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