Solving the asset allocation puzzle

Aug 6, 2021
  • Michael Lane

Sometimes the best path to a better life is the most basic one. Eat a healthy diet and exercise often. Avoid excess in most things and focus instead on moderation. If it sounds dull, it can be. But you get the picture.

For investing, the comparable activity is asset allocation, that blend of stocks and bonds that investors hold over the long term. Determining investors’ goals, risk tolerance and time horizon is typically part of an initial conversation with a financial advisor, resulting in a mix of assets that helps put those clients on the path toward meeting their goals.

Contrast that with the excitement of picking a hot stock correctly and having a big payday or having the foresight to exit the market just before a big crash or reentering right before the rebound. It can be exhilarating if you are lucky or good enough to succeed. I know from experience, even as a very structured, rules-based investor, I can’t help but watch a few individual securities and wonder “what if…” If only I had bought at the low and sold at the high, my wealth could have multiplied by 7-10x in just a year! But most market experts agree that it is extraordinarily difficult.

A few months ago, at the height of the hubbub surrounding trading stocks such as Game Stop through online forums including Reddit, I wrote about the difference between speculating and investing. What we saw earlier this year was a surge in speculating, pure and simple. For most people, however, the best course is to develop a plan, and stick to it. That’s investing.

Not surprisingly, there’s a great deal of research to support the soundness of maintaining a disciplined asset allocation approach. The groundbreaking paper on the topic by Gary Brinson and Gilbert Beebower from 1986 showing that more than 90% of the variation of returns among the pension plans they studied was due to asset allocation, not manager selection1.

In the decades since that study was released other research has painted a more complex picture. Factors such as manager fees and tax implications, for example, have an impact on investors’ long-term returns. But there seems broad agreement among most financial advisors that investors should focus on asset allocation decisions first and foremost.

Having said all of this, my colleague Andrew Sweeney reminded me in a conversation recently, that it is important to emphasize how asset allocation decisions can and should change over time, particularly for investors holding portfolios for 10 years or more. There is a lot of middle ground between “trying to time the market” and “buy and hold the same asset allocation for life.” The most disciplined advisors I know understand those subtleties, but it is an important conversation for every investor to have with their advisor. It’s a conversation I’ve had several times with BlackRock’s Andrew Ang about factor investing as well. Should you just tilt to factors and hold on for life, try and time them, or should you overweight or underweight factors during specific economic regimes? Or more importantly, as one grows closer to achieving their goals, should their factor exposures change? 

This is an especially important consideration in the current market environment, which is truly unique. We have a world emerging from a pandemic, economies rebounding, but variants of the virus still pose a threat, and now growth appears to be slowing, which could be temporary or long lasting. We’ve seen higher inflation appear, along with the potential for higher taxes. All of these suggest it may make sense for some investors to adjust their asset allocations. For example, they may want to shift towards more TIPS over nominal Treasuries in a fixed income portfolio. And there may be a need to evaluate the degree one is tilting to various asset classes, factors and sectors.

During the conversation with Andrew Sweeney, he shared how he had recently taken a look at the so-called “value rotation” we saw in recent months. At the time, many investors were shifting towards value stocks, which historically have performed better in an economic rebound, and out of growth companies. From November 2020 to the end of June, the Russell 1000 Value Index outpaced the Russell 1000 Growth Index 31% to 19%. But within value, there are several options with varying costs and depth of value exposure, and the returns varied by as much as 7%. Assume a hypothetical standard 60/40 portfolio, which has a 10% allocation to growth within equities. Moving from the Russell 1000 Growth Index into the Russell 1000 Value Index would have led to ~1.2% of additional returns. Moving that allocation into the higher performing MSCI USA Enhanced Value Index instead would have resulted in ~1.9%.2 Simply put, the asset allocation decision to buy value would have been more consequential to the bottom line than picking the right option within the value space.

All of this raises the question: How do you draw the right balance between adjusting asset allocation, gaining a desired securities exposure, but not excessively trying to time the market? There is no easy answer, but here are three straightforward guidelines.

Stay the course, but tweak on the edges.

As the example above shows, most allocation adjustments should and will involve minor changes to the portfolio. It is important to still stick with your broad asset allocation that is geared towards meeting your clients’ goals. Think of it this way: Adjust to broader macroeconomic shifts that potentially should last for a few months at least, rather than events that will fade in a few days or weeks. And most importantly, when tweaking on the edges, make sure those tweaks align with how close to achieving the desired goal the client may be. No sense in taking on undue risk and volatility if close to achieving the goal.

Revisit client needs and risk tolerance.

It may seem an obvious area of discussion for client meetings, but in my experience, advisors are constantly reminding me that they have to remind clients as to the tradeoff of a disciplined investment policy and short-term speculation. Although a basic premise, this can be especially important when clients wish to discuss the latest investment topics, whether SPACS or GameStop. The difficulty of trying to measure a client’s risk tolerance is the concept of recency bias. When returns are up, clients tend to believe they are more risk tolerant but when they are declining, they tend to have a propensity for more conservative investments. Help clients understand this, and have the conversation about what risks they can afford to take based on where they are on the path to achieving their goals, and how tweaks to the portfolio can help them achieve, or as importantly, maintain their achievement of a specific goal.

Focus on what you can control.

Investing obviously involves risk and nothing is certain. A well-considered asset allocation adjustment may not work as planned. However, you can focus on what you control, by staying the course with the broad allocation, and, most importantly, consider the vehicle. A low-cost solution that seeks to track an index such as an ETF can’t guarantee results, but it can help manage costs and is an excellent asset allocation tool.

Personally, the basics in life are often what achieve the best results. As a lover of healthy food and fitness fanatic, leading a healthy life has its underrated pleasures, as does helping clients achieve their goals by focusing on a disciplined, fundamental asset allocation that can best achieve the desired outcome, while adjusting it when necessary. And of course picking the right tools to maximize results.