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The Hidden Danger in Asset Class Investing

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In late 2008 the world financial system was on the verge of shutting down—and with one or two notable exceptions investors had nowhere to hide. Every asset dropped in price: stocks, bonds, commodities, real estate and precious metals—there wasn’t any major investment class that escaped. Across the investment world correlations between securities all rose to “1” and diversification failed.

In the search for investment lessons from the financial crisis, the obvious suspect was the inability of traditional sources of diversification (stocks and bonds) to mitigate the damage caused by the market’s collapse. As a result, considerable time and energy have been spent evaluating what kind of alternative investments would have been unaffected by the meltdown and incorporating them into new ETFs and other marketable securities.

If I’ve learned anything in my time in the investment world, it is that there is no perfect strategy, and no perfect outcome. “Don’t put all your eggs in one basket” is an old adage because it is a brilliant insight and it has withstood the test of time. Diversification works, sometimes superbly, sometimes minimally. But it cannot work all of the time—nothing works all of the time. At some point a set of circumstances will arise that will foil even the most sophisticated, most comprehensive and most intelligently conceived strategy. The investment lesson from the financial crisis cannot be the failure of something that will never work 100% of the time.

No matter how successful, consistent or persistent the returns, every strategy is imperfect in some way. Therefore it is critical that investors understand what they risk when their chosen strategy fails. Will the damage be merely inconvenient or will it be catastrophic? Not understanding the vulnerability of a successful strategy is a recipe for disaster, as the following familiar story illustrates.

Hurricane Katrina made landfall early on the morning of Aug. 29, 2005. An hour or two later it slammed into New Orleans. Citizens and city officials had received ample warning and were well prepared for the potential damage. Storms in the Gulf of Mexico are a common occurrence, and local, state and federal agencies had a long history of coordinating their individual and collective responses.

Yet when the levees were breached that afternoon and New Orleans began to flood, a totally unexpected set of challenges arose. Despite years of experience with previous storms and floods, FEMA’s operational structure was incapable of adjusting its response to the unique set of conditions it now faced. With regular channels of information compromised, what normally would have been a smooth integration of effort with local government agencies turned into a Kafkaesque power struggle over who had ultimate authority. Government officials could not see the flaws in their own thinking, and months later were still blaming the breakdown on the unusual circumstances of the storm.

In The Checklist Manifesto, Atul Gawande explains that the complex and rapidly changing needs brought on by the combination of the huge storm and the flooding overwhelmed the centrally based command-and-control structure on which government agencies relied. What the Katrina disaster demanded was for the decision making to be moved to the edges. There wasn’t the time, communication or logistics available to fit the requirements of a centrally directed command structure.

Wal-Mart quickly realized that reality and instructed store managers to do anything they felt was needed to help their community—and the company would back their decision. As a result Wal-Mart was able to provide emergency supplies and drugs days ahead of FEMA.

What Gawande illustrated in just a few pages is what happens when otherwise sincere, motivated and well-intentioned individuals hold too tightly onto a world view, which despite past success, no longer relates to the facts on the ground. With this in mind we can reframe our perception of the financial crisis and gain some valuable clarity.

Crisis Reconsidered

In the decades leading up to 2008, modern portfolio theory changed the way the investment world perceived the challenge of investing and the construction of portfolios. With the advent of the Internet and the explosion of information and connectivity, coverage of big macro issues became commonplace—as did the ability of investors to exploit them. The simplicity and ease of diversification by asset class instead of the more complex and time-consuming task of choosing from among a number of individual securities revolutionized the investment process and mindset.

Conceptually and in practice, asset class investing was compelling. It simplified the universe of tens of thousands of individual securities by categorizing them into a few dozen logical and understandable components. With the explosive growth of ETFs, investors could design their portfolio to have optimal exposure to whatever set of asset classes they thought best. As a result there were more options to diversify than ever before and the diversification of truly enormous sums of money could be accomplished with a few clicks of a mouse in a matter of seconds.

All of this was (and is) good. However, because asset class investing was built on a completely macro view of investing, it necessarily severed the link between investors and their actual underlying investments. In the fall of 2008 that disconnect, which had not been a meaningful impediment to past success, led investors to make catastrophic choices at the most critical juncture. With only a macro view of the world, all that mattered was the growing fragility of the financial system—which was both real and terrifying. And with no connection to the realities of the underlying investments, asset class investors had no rational offset to the legitimate macro threats they observed, and so they concluded that their only option was to sell.

Jeffrey Bronchick of Cove Street Capital reminds us how an asset class mentality can blind investors to an important but obvious reality: “… there is inevitably a management team discussing the same issues we are and adapting the business portfolio and processes to the uncertainty of the future. This fact is one of the key misunderstandings of ‘stock investing’ and is a crucial reason why we see our job as investing in ‘businesses’ and not in ‘asset classes.’ It is a crucial distinction to make.”

Like the government officials’ response to Katrina, asset class investors’ inability to see anything but the big picture led them to make unfortunate choices at the worst possible time. It continues to blind them today as they cling to the mistaken belief that the losses they suffered in the 2008 stock market crash were due to the failure of diversification—and that the solution is to search for more and/or different kinds of asset classes.

The lesson of the financial crisis and the lesson of Katrina are the same: Our ability to predict or control future events is, at best, minimal; the only thing truly within our control is how we respond. So instead of searching for strategies that promise to help avoid the risks of future bad markets, investors should be focusing on strategies that actually help them avoid the risks of future bad choices.