“Fiddler on the Roof” is one of the most enduring musicals written. It first previewed here in Detroit in 1964, and I see that it is returning here for the umpteenth time during the 2020 season to the same theater where it had its original tryouts 55 years ago. I’m sure there is a regional or touring company still performing it somewhere near you in the year ahead as well. If not, 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 present throughout the remainder of the production—the villagers trying to maintain their traditional approaches to life, marriage, and family versus the 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.
Reason #1: Traditional allocation requires investors to accept two risks: market crashes and low returns
This is a problem because history demonstrates traditional asset allocation’s main defense against market crashes—diversification—is simply not sufficient. In the last two market crashes, a balanced portfolio lost more than one-third of its value. In the 1930s, a portfolio composed of 60% bonds and 40% stocks would have lost 63%!
At the same time, the diversification, which can fail to deliver enough defense when the market crashes, may also result in mediocre returns when the market is 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 with multiple asset classes, the “best” return possible is limited to the average return of the asset classes weighted by a static formula.
As Charles Sizemore, CFA and editor and portfolio manager for economic forecasting and investment research firm Dent Research, has written repeatedly in Forbes, “Accepting a traditional asset allocation is accepting the possibility for disappointing returns in the years ahead. If you want better performance, we need to look elsewhere.”
Reason #2: When confronted with a market crash or low returns, the average investor abandons the approach
The financial-services industry knows this. For the last few years, I’ve heard many major providers give financial advisors 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.
When I say “substantial periods,” I mean most of the time. A study I did some years ago showed that the average investor in the Dow Jones Industrial Average, an index of the bluest of blue chips, spent 76% of his or her time in the stock market going through a market crash and returning to breakeven.
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 methodology was not based on an independent, reproducible methodology the investor can understand, and it was not grounded in a personal investment philosophy. These deficiencies mean that the investor will not have the understanding and belief in the allocation that is 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 look at their investment results more often than the once a year experts have found to be optimal. Investors are reactive. They move based on emotions and thus typically make less from their investments than the assets they invest in due to poor tactical decisions.
Investors find it extremely difficult to practice both of the actions upon which traditional asset allocation relies. As we have discussed, they cannot hold on in loss situations, and when it comes time to rebalance, they have trouble taking money from top-performing investments and putting 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. I 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 advisors look at average returns and volatility numbers when an investment is proposed rather than focusing on measures that reflect their likely real-time experience and how they are likely to react to them.
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 in terms of how it relates to the S&P’s.
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 their potential for loss in terms of dollars instead of the percentages that appear throughout industry marketing materials. For example, which do you think has more 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 has more emotional content that an investor must sort out in real time than the other.
Similarly, on the subject of returns, investors are used to seeing compounded average growth rates (CAGR) reported for all of their investments in the sales literature that they rely on when they invest. But CAGR can hide as much or more than 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 have a better sense of whether the returns are something an investor can live with, he or she should look at the individual yearly, quarterly, or monthly returns over the investment record that resulted in the CAGR number. 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? Beware: The 10-year industry charts that are common today do not include a single correction of 20% or more! Yet the average bear market in the S&P 500 since 1928 slashed 39.4% from stock prices.
Failure to realize the limitations of the industry sales numbers leaves most investors ill-prepared for the real-world situations with which they must deal. 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 ignores its historical return and risk characteristics. It underappreciates the impact of those real-world results on investor decision-making. It ignores the financial behavior of investors and is insensitive to their natural tendencies. Finally, it is sold in reliance on overall risk and return numbers that have little connection to what is actually important to investors as they weather daily life and financial storms.
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 becoming a “rich man.” Rather, employing all of the tools modern investing can—“miracle of miracles”—bring to the fore is a better way. “To life!”
The major market indexes finished up last week: The Dow Jones Industrial Average gained 0.91%, the S&P 500 Stock Index rose 0.62%, the NASDAQ Composite climbed 0.93%, and the Russell 2000 small-capitalization index gained 0.75%. The 10-year Treasury bond yield rose 20 basis points to 1.74%, causing bonds to decline sharply in value. Spot gold closed at $1,489.10, down $15.65 per ounce, or 1.04%.
Despite last week’s stock market advance, if we take a step back and look over the longer term, it’s clear that the stock market has hardly moved at all over the last year. In fact, stocks are within 2% of where they were one month ago, three months ago, six months ago, and, yes, 12 months ago!
And if we take a giant step backward and look at the entire rally from the March 9, 2009, market bottom, we can see the stair-step progression it has traced. Today we sit on the third step of this rally. In the past, when the rally has stalled in a 4% range between the high and low of its 200-day moving average, the market has had a strong tendency to move higher once it breaks out like it did last week.
This has happened just 12 times in S&P 500 history. One month later, stocks were higher all but one time back in the 1940s. The same was the case one year later, with gains averaging over 18%.
Last week’s gains came despite weaker-than-expected economic reports. Two-thirds of the reports failed to meet economists’ estimates. Yet inflation was stable to lower, and the University of Michigan Consumer Sentiment Index strongly outpaced the expert estimates.
At the same time, earnings reporting season commences this week. While the preseason saw most S&P 500 early reports posting better-than-expected earnings, hundreds of additional companies still to report were downgraded rather than upgraded. Still, this is a contrary indicator that tends to support about a 3% advance over the next 60 days if the historical probabilities work out.
Sentiment still is negative. In fact, the bullish sentiment of small investors in the American Association of Individual Investors (AAII) Sentiment Survey was at its lowest level since 2016 last week—and in the bottom 2% of levels ever hit. Historically, this is bullish.
The weight of the evidence would seem to support a rally through the end of the year. The fiddler plays on, but with the current news environment, the roof appears pretty slippery.
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