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