Three Lessons on Strategic Allocation From the Financial Crisis

One of the biggest misconceptions about strategic asset allocation is that it’s an outmoded “buy and hold” approach. In truth, strategic allocation done right has to be a dynamic process: forward-looking, flexible and consistently revisited.

There are other important yet overlooked lessons about strategic allocation to take away from the financial crisis. Many investors took double-digit losses and all but fled to cash in 2008, giving up on the promise of diversification. But there is a danger in throwing out an otherwise effective approach, just because it “didn’t work” for a relatively short, and highly unusual, period in our financial history.

Lesson 1: Returns are as important as correlation. Supposedly, strategic allocation didn’t work during the crisis as all asset classes became highly correlated. That is, corporate bonds did as badly as government debt, large stocks as small, international markets as the U.S. But in reality a well-diversified investor likely could have done better than a non-diversified one, if the investor held pat over a reasonable time frame.

For example, the Russell 3000 Index was down 6.6% annualized over the three-year period ending September 2010 whereas emerging markets only lost 1.2% annualized over the same period. The Russell 3000 gained 0.92% annualized over the five years ending in September 2010, but emerging markets rose 13% annualized and bonds, as represented by the Barclay US Aggregate Bond Index  returned over 6%. So even though correlations became very high between asset classes during the 2008 crisis, the return differentials over more reasonable time frames suggests that broad diversification is still a benefit to portfolios.

Lesson 2: Models are guidelines, not absolute predictions. There is an aspect to investing that can be modeled relatively well. But there are also “black swan” events, aberrations that simply can’t be modeled. The question is really how to handle

 

such unknown risks, as opposed to preventing them all together.

I’m reminded of an example provided in Dance with Chance, by Spyros Makridakis, Anil Gaba, and Robin Hogarth, who argue for understanding the difference between subway events and coconut events. Subway events are those we can model: If you take the subway each day at a certain time you can reasonably predict when you’ll get to work. Coconut events are impossible to model yet low-probability scenarios: If you take a tropical vacation and stand under a coconut tree, you have no way of predicting whether the heavy fruit will fall and hit you in the head. You can, however, mitigate potential damages by buying accident or life insurance.

A similar line of reasoning applies to investing. Strategic allocation models for an expected outcome (return), based on a client risk tolerance (variance). For black swan events, a discussion about the pros and cons of some type of portfolio insurance (usually in annuity form), could make more sense than giving up on modeling all together. After all, those who abandoned their strategic allocations and fled to cash in 2008 largely missed the chance to recoup losses when the markets snapped back in 2009.

Lesson 3:  Asset allocation is like running a marathon, not a hundred-yard dash. This is especially true in more aggressively positioned portfolios. Before the crisis, many investors became complacent in assessing their own risk tolerance. Today, revisiting risk tolerance for the long haul, on an ongoing basis, is critical. Simply rebalancing on a periodic basis can potentially add one-half to a full percentage point to performance.

Of course, it’s often in hindsight that we realize we should have rebalanced our holdings to sell bonds and buy stocks at the market’s low point. For the advisor and investor alike, it takes tremendous discipline to rebalance even in the worst of times, such as in early 2009. Ultimately, investors need to understand that short-term volatility risks exists, especially today, and if they can’t bear intermittent dips then a more conservative allocation is always an option.

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