Asset Allocation..

The “Naughts” were a disaster for equity investors

The first decade of the 21st century was the worst ever for U.S. equity investors—worse even than the Depression-era 1930s. In this “Lost Decade,” stocks returned -1% per year, losing 3.5 percentage points against inflation and contradicting the conventional view that stocks always beat bonds over the long run.

Few experts questioned conventional wisdom

A few voices had challenged this equity-centric view. More than a decade ago, Yale University professor Robert Shiller in Irrational Exuberance warned that low dividend yields tend to be followed by price declines. In a prescient 2002 Financial Analysts Journal article, Rob Arnott and Peter Bernstein observed that the forward-looking equity risk premium might be zero or even negative.

A more diversified portfolio would have fared better

If investors had eschewed the equity-centric 60% stock / 40% bond portfolio, they could have done better. A portfolio of 16 equally weighted asset classes including emerging market stocks and bonds, TIPS, high-yield bonds, REITs, and commodities would have generated a 6.8% annualized return, beating a 60/40 portfolio by 4.5 percentage points (and inflation by more than 4 percentage points) for the decade ending December 31, 2009. By substituting the S&P 500 with the FTSE RAFI US 1000, the broadly diversified portfolio of 16 equally weighted asset classes would have boosted the return to 8.5%.

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Investors need to adopt realistic expectations

How can investors avoid repeating the mistakes of the Lost Decade? For starters, they should adopt realistic return expectations. Too many investment plans use long-term historical averages in setting return targets, assuming 7-8% a year for a classic 60/40 portfolio. But those returns are unlikely to repeat themselves, especially if the economy enters a reflationary environment that typically punishes valuation multiples. The “3-D Hurricane” of soaring deficits, escalating debts, and changing demographics means inflation is all too likely to occur in the years ahead.

“Building blocks” offer a simpler way of projecting returns

Instead, a “building blocks” approach offers a simple and superior method of projecting future returns. For equities, we sum the current dividend yield, real earnings growth, an inflation estimate, and expected price-to-earnings multiple expansion. With dividends less than half their historic average of 4.5%, real earnings growth around 1.5%, and near-term inflation between 2 to 3%, a realistic return expectation is around 6%just over half the level of the past 30 years. For bonds, the current yield to maturity reliably predicts future returns, or roughly 2.2-2.6%. A 60/40 portfolio would generate a return between 4.2-4.6%not a very encouraging outcome. So what next?

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A new approach to asset allocation is needed

If a more diversified, less equity-centric approach would have generated a 4.5% return over the 60/40 stock/bond portfolio during the Naughts, what about the future? Yesterday’s asset allocation will not work for tomorrow-- past is not prologue. Risk premiums fluctuate, sometimes wildly. Yet many investors maintain a relatively constant risk tolerance, similar to their 60/40 policy portfolio.

Unconventional assets may offer better returns

The first part of the answer is to consider other asset classes; unconventional assets sometimes are priced to offer better returns. Investors should examine an array of non-traditional asset classes, such as emerging market stocks and bonds, high-yield bonds, bank loans, and long TIPS. In addition, non-price weighted indices and well-crafted low-risk equity strategies should be considered.

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Managing the asset mix actively

Investors also should actively manage the asset mix, available through Global Tactical Asset Allocation strategies. They should take long-term risk when risk-bearing is likely to be rewarded, and a conservative, well-diversified posture when it is not. Rich forward-looking risk premiums typically prevail when investors are terrified. As Warren Buffet suggests, investors should be “greedy when others are fearful and fearful when others are greedy.”