“Tradition”? Not in asset allocation

By Jerry Wagner

“Fiddler on the Roof” is one of the most enduring musicals ever written. It first previewed here in Detroit in 1964, and regional and touring companies still perform it today. And, of course, the movie version is always available.

One of the most important songs in the show is the opening number, “Tradition.” It sets up the conflict that runs through the rest of the production—the villagers trying to maintain their traditional approaches to life, marriage, and family versus a more modern way of doing things. Spoiler alert: Modern (mostly) wins.

In my own field of asset management, the conflict continues. Yet I believe there are many reasons why traditional asset allocation does not work.

Clarifying notes

•  When I say “traditional” asset allocation, I mean passive or static asset allocation. And don’t be confused by firms claiming to use active asset allocation when all they do is make quarterly tweaks without making tactical decisions. That is not the dynamic management I would contrast with “traditional” asset allocation. •  When I say “traditional asset allocation does not work,” I don’t mean mathematically. I mean in practice for most people.

Reason #1: Traditional allocation requires investors to accept two risks: market crashes and low returns

This is a problem because history demonstrates that traditional asset allocation’s main defense against market crashes—diversification—may not be sufficient to prevent substantial losses during severe market declines.

And that same diversification can limit returns when markets are rallying. Inherent in the design of “traditional” asset allocation is the truism that it cannot deliver the return of the best-performing asset class during any period. Because static allocations diversify the portfolio across multiple asset classes, the “best” return possible is limited to the average return of the asset classes weighted by a static formula.

Reason #2: When confronted with a market crash or low returns, the average investor abandons the approach

The financial-services industry knows this. Over the years, I’ve heard many major providers give financial advisers the same message at industry gatherings: Forget providing or finding superior asset management. Be satisfied with buy-and-hold indexing. Concentrate instead on just two services: bringing in assets and talking investors through the substantial periods consumed by market crashes and low returns.

Of course, there are many reasons why investors give up on traditional asset allocation. Most of them are related to a lack of conviction.

The investor did not create the allocation that he or she is required to stick with. The allocation was not based on an independent, reproducible methodology the investor can understand, nor was it grounded in a personal investment philosophy. These deficiencies mean the investor will not have the understanding and belief in the allocation necessary to stick with it when the financial market environment turns negative.

In addition, sticking with a traditional asset-allocation plan flies in the face of all we know about investor behavior. Investors are averse to loss; we are told they fear loss more than twice as much as they appreciate gains.

Further, investors are impatient. Many check their investment results more often than the once-a-year frequency experts have found optimal. Investors are reactive. They act on emotion and thus, because of poor tactical decisions, typically make less from their investments than the assets themselves return.

Investors find it extremely difficult to practice both actions on which traditional asset allocation relies. As we have discussed, they cannot hold on in loss situations, and when it comes time to rebalance, they struggle to take money from top-performing investments and put it into their poorest performers.

Reason #3: The financial industry does a lousy job of creating expectations that match reality

Investor risk tolerance is not static, as so many assume. We find that the answers to suitability questionnaires can be influenced by the state of the market. In good market environments, investors say they are more comfortable with risk than when asked the same questions in the midst of, or just after, a market crash. As a result, they will take on riskier strategies or asset classes near market tops and will only consider defensive positions at market bottoms.

Traditional asset allocation fails because it is not a true match with the investor’s tolerance for risk and low returns. Investors and their advisers look at average returns and volatility numbers when an investment is proposed, rather than focusing on measures that reflect investors’ likely experience and reactions.

Investors are more likely to get a real sense of an investment’s suitability if they look at its maximum loss rather than its volatility (standard deviation). This is so even if that volatility is explained relative to the S&P 500 Index.

This is because volatility is not the same as risk. We like volatility when it occurs in a positive market move. It’s the downside variety that investors truly fear.

Investors may better understand risk if they think about potential loss in dollars instead of the percentages that appear throughout industry marketing materials. For example, which do you think has a greater impact on an investor with a $100,000 account: a 33% loss or a $33,000 loss? You can say that they are the same, which is true, but one carries more emotional weight for an investor in real time than the other.

Similarly, on the subject of returns, investors are used to seeing compound average growth rates (CAGR) reported for their investments in the sales literature. But CAGR can hide as much as it reveals.

It assumes that the investor can stay invested. However, as we have just discussed, few investors have the conviction and personality to do so. In addition, a few extraordinarily good periods may allow the single number to mask the downturns, sideways markets, and low returns that consume most of the time during which the overall return was generated.

To get a better sense of whether the returns are something an investor can live with, he or she should look at the individual annual, quarterly, or monthly returns over the period used to calculate the CAGR. Were there long periods of so-so returns during which the investor would have lost patience? Were there down times when the investor would have thrown in the towel? Overall, was the CAGR compiled over a period that included a full market cycle?

Failing to recognize the limitations of industry sales numbers leaves most investors ill-prepared for the real-world situations they must face. These industry standards provide investors with no real basis to build conviction for the methodology that would allow them to stick with the traditional asset-allocation approach in good, bad, and in-between times.

Traditional asset allocation does not work

Traditional asset allocation fails to adequately account for its historical return and risk characteristics. It underappreciates the impact of those real-world results on investor decision-making. It ignores investors’ financial behavior and is insensitive to their natural tendencies. Finally, it is often presented using overall risk and return numbers that have little connection to what matters to investors as they weather daily life and financial storms.

For these reasons, we have developed our QFC Multi-Strategy Core offering. QFC Multi-Strategy Core moves beyond traditional asset allocation to help advisers and investors build portfolios using many different dynamically managed core strategies. This turnkey “strategy of strategies” portfolio employs three levels of risk management (within each actively managed mutual fund, among all of the funds used in each strategy, and between the QFC strategies) and is available in five risk profiles, from conservative to aggressive. And because it uses our subadvised Quantified Funds, applicable fee credits can offset all or part of our advisory fee.

Investing can be as precarious as a fiddler on a roof—and just as solitary. Relying only on tradition from “sunrise” to “sunset” may not be the best way to become a “rich man.” Rather, “miracle of miracles,” modern investing gives us some tools to bring to the task. “To life!”