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As seen in the August 2003 issue of Financial Planning magazine.

Rethink Risk

By: Jerry C. Wagner

 

Passive asset allocation simply isn't enough these days. Advisers should also consider dynamic diversification strategies

 


Bear Picture

The bear market of the last three years has clearly shown the weakness of the primary tool used by the investment advisory industry to manage risk — passive asset allocation. While it has its place as one method of risk control within an investor’s portfolio, it is not the only method. Financial advisers owe it to their clients to understand alternative methods of risk reduction and to be prepared to implement those tools when appropriate. They should now broaden their horizons and also consider market timing, dynamic asset allocation, and strategic diversification.

Many planners may be using a passive asset allocation portfolio because it’s the only method they know to manage risk. Basically, they use historical statistics of return, risk, and correlation to allocate a portfolio among different asset classes or funds representing those asset classes. Once they make the initial allocation, these planners review the portfolio quarterly, yearly or whenever they can drag the client back in for an appointment. They then reconsider the allocations based on the investor’s circumstances and risk tolerance, make small changes and rebalance the portfolio to the proper percentage allocations.

Passive asset allocation is risk management based on combining non-correlated asset classes to create a portfolio with risk lower than the average risk of its component parts. Because it’s passive, it cannot respond to evolving market conditions. By definition, it can only deliver mediocre returns (the average return of its component holdings). It takes almost superhuman discipline, requiring proponents not only to hold on to investments that have already taken serious losses but also to sell portions of the top performers in order

to buy more of the losing investments. Last, it subscribes to the almost unamerican ethic that if you work less at your investing, you’ll do better.

In real-life experience over the last five years, financial professionals using passive asset allocation have become somewhat disillusioned. Returns seriously lagged during the bull market, and then adding insult to injury, losses were deeper than expected during the market crash. Previously non-correlated asset classes were suddenly moving in lockstep as prices collapsed. The financial press responded with front-page stories speculating loudly about the “asset allocation hoax.” But there was no hoax, only a failure to understand that there is no holy grail approach to investing.

There are other options, and market timing, despite being one of the most criticized terms in the lexicon of investing, is one of them. Many mutual funds and variable annuities, consistent with their obvious conflict of interest on the sub- ject, denounce it. Yet it seems to be forever winning over converts. In a recent comprehensive study of the advisory industry, Financial Research Corp. of Boston found that active management was the fastest growing segment of the financial adviser industry. The industry’s trade association, the Society of Asset Allocators and Fund Timers (SAAFTI), has grown from five firms in 1989 to hundreds today.

The promise of market timing is, of course, to buy low and sell high. (Will Rogers, professing to know the secret of market timing, said, “If it don’t go up, don’t buy it.”) It differs dramatically from passive asset allocation in that it is not diversified and usually involves a 100% in – 100% out investment in the asset class with the highest probability of advancing based on the market timer’s system or skill.

Still, the conventional wisdom on the Street is that "studies show market timing doesn't work."

 


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