Rebalancing to a fixed asset mix can be dangerous

“Just because other kids do it doesn’t make it right.” How often did we hear that admonishment growing up? How many of us have repeated it to our children? Yet, we don’t always apply this theory when making investment decisions.

Many investors use a fixed asset mix and rebalance to it periodically. They consider “buy and hold” an incontrovertible truth, and view selling assets that have risen and buying ones that have lagged as an elegant way to sell high and buy low. But the underlying premise is flawed.

A fixed asset-mix strategy assumes that asset class returns, risks and correlations remain fixed over time. But, theory doesn’t reflect reality. Buying and holding works best if investing time horizons are long enough to make back losses from previous cycles. If you had a perpetually long investing time horizon, this would be a simple and effective solution. But times aren’t simple, and aggregate horizons are getting shorter.

For baby boomers, who control 80% of North American wealth, fifty-year investing time horizons are no longer the norm. Retirement approaches. At age 65, 20 years is still a long time to invest, but unpredictable health and personal needs make the last half fraught with uncertainty. Ten-year periods of zero return are possible, and increased volatility can do irreparable damage to you portfolio. There must be a better way.

Getting the mix right is arguably the most important aspect of investment decisions. The strategic mix provides an expected return based on each asset’s historical performance. Fitting weighted, expected returns to your financial objectives establishes the strategic asset allocation. But there are problems.

Why projections are not always accurate

Do historical returns indicate future returns? What future return should be used for bonds today? Can we trust historical equity returns, given aging global demographics? Will personal spending decline and permanently impair GDP growth? Most investors give more weight to today’s data or recent experiences, and then they extrapolate. We can’t avoid making projections, but returns are not nearly as predictable as risk.

The autocorrelation of VIX — the implied volatility of S&P 500 options — is a staggeringly high 85% on a monthly basis and 98% daily. This means that yesterday’s VIX explains 98% of today’s. Returns, on the other hand, have a daily autocorrelation of only 4%. Today’s return tells us virtually nothing about tomorrow’s return. Because returns lack persistence and so many projections are required that reduce the confidence of the output, we should manage risk instead of return, just like sophisticated pension and endowment plans do. ETFs put this strategy within reach of every investor. How would this change standard operating procedures?

Asset allocation

Asset allocation remains important. But because the focus is on managing risk, changing asset allocation becomes a key tool in your arsenal, as opposed to the only strategy.

Costs

Keeping costs low is an active strategy. In a world of uncertainty, costs are certain and usually known in advance. Using low-cost products like ETFs and minimizing trading are two obvious things even novice investors can do.

Security selection

Security selection in a diversified portfolio has a diminishing impact on returns.

When constructing a risk-based portfolio, ETFs are ideal building blocks because they generally provide a more stable packet of pre-diversified volatility than individual stocks.

Professional investors have difficulty successfully timing the market consistently. So is changing asset mix to maintain consistent portfolio risk considered market timing? Market risk is the problem and needs to be managed. Which of these two approaches is more responsible?

• Rebalancing to a fixed asset mix and being subject to extreme changes in market volatility; or
• Reducing a portfolio’s risk when market risk is high, and increasing the portfolio’s risk when market risks are low to maintain a consistent risk exposure.

The Capital Asset Pricing Model (CAPM) divides risk into market and specific risk. Modern portfolio theory (MPT) tells us we can reduce specific risk (risk associated with a single asset) through diversification, but CAPM says we are stuck with market risk. For those with relatively short investing time horizons, market risk must be managed.

MPT also asserts that combining uncorrelated assets yields a portfolio with higher expected return and lower overall risk. But, MPT assumes returns are normally distributed, that markets are efficient, and that investors act rationally; the real world is different. CAPM implies that higher risk yields higher returns, but the minimum volatility phenomenon shows that it doesn’t. The underpinning for rebalancing to a fixed mix are found wanting. Remember your parents’ rebuke: “If everybody jumped off a cliff, would you follow them?”