Dealing with risk — diversified asset allocation

Diversified asset allocation, the belief system that most investment advisors preach—has the “right”  mix of stocks, bonds, real estate, commodities spread out over the entire world.   This investor age dependent mix is rebalanced, typically quarterly, by reducing your investment in areas that have performed well and increasing your stake in areas that are now underweighted—presumably waiting their turn to perform.

I don’t think this is a bad strategy, but it does make the assumption that the future will be like the past (e.g., equities average around 10% growth per year over multi-decade periods, and that some assets classes like bonds and commodities tend to counterbalance trends in equities. For at least equities, the 2000 to 2010 time period has not been kind to this strategy—ignoring dividends the growth has been negative on the broad based markets.   Another trend is the recent synching up of commodities, and lower quality bonds with the equity markets.  This may be due to the rise of the ETF, which has made it much easier to get in, and out of things like gold, oil, and bonds.   Instead of counter balancing each other, they are increasingly moving in tandem—which increases the potential gains and risks.

Summarizing, from a risk management standpoint this approach has a fair number of issues:

  1. I don’t think the past reliably predicts the future.  There are underlying assumptions about asset correlation and long term growth that look increasingly suspect
  2. Although this is the probably the predominate investment strategy in the USA–because the vast majority of people just do what their broker recommends—it delivers truly gut wrenching poor performance during big bear markets.  People have their entire life savings invested in alignment with this strategy, and they see many years of gains erased in a few months.   The doomsayers come out in force, the press headlines the losses, and the conventional wisdom states that stocks are dead.   The end result is that a significant number of people capitulate near the bottom—bailing out of their investments at the worst possible time.

One of things I do like about diversified asset allocation is that its disciplined periodic rebalancing  takes profits on winners and reduces your exposure to the hot sector.  While an anathema to the momentum player, taking some of your winnings off the table periodically reduces your exposure to speculative bubbles.  The bursting of these bubbles is notoriously hard to predict, and they go south very quickly when they do.

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