Asset Allocations

The concept of allocation is usually considered one of the main guiding principles for safe investing. The idea is that you are supposed to be diversified in various stocks or asset classes. This elementary risk management tool seems to be common sense. It is even reflected in the English expression “don’t put all of your eggs in one basket”. It is not only English. Almost the exact phase exists in French. The Chinese follow the example of an animal; the smart rabbit has three holes. I have no question that in life, it is always a good idea to have alternatives, but for investors, especially recently, the practice may not always result in achieving its goal.

Money managers, financial analysts and even courts are fond of asset allocation rules. One of the most common involves the allocation between stocks and bonds. The ‘safe allocation’ is supposed to be 60 per cent of a portfolio in equity and 40 per cent in bonds. So sacred is this allocation that it has a corollary based on age. At age 25 you are supposed to have 75 per cent of your assets in stocks and 25 per cent in bonds. By age 50 the portfolios should be balanced, because as you approach retirement you naturally want less risk. I recently saw a US bank that went even further. It had about eight categories of risk tolerance each with its own set of allocations from no risk which would be 100 per cent cash to high risk which would be 100 per cent equities.

The problem with these rules is that they can be terribly misleading. For example, a solid portfolio is supposed to be made up of different stocks. The theory is that the movement of an individual stock is supposed to be based on an individual company’s financial fundamentals. This concept is the basis of a vast industry of stock analysis and stock picking. Recently this has not been the case. Stocks have risen and fallen together without regard to their fundamentals. The correlation of the 250 biggest stocks in the US S&P stock index over the past month had been the highest since 1987 at 81 per cent.

Other relationships have exhibited some novel patterns. In theory owning government bonds and gold should be a good allocation because they tend to move in opposite directions. Gold is traditionally a hedge against inflation. When an economy is growing rapidly and inflation is rising, you should own gold. In contrast inflation is the enemy of government bonds since their value is diminished and the returns may result in negative yields. But recently US treasuries and gold have risen together. The explanation is that they are both supposed to be “safe havens”. Although I can’t think of anything safe about buying either asset. Gold may be at the top of a bubble. Deflation may be more of a problem than inflation, while the value of dollar denominated US treasuries continues to fall relative to other currencies.

Owning both emerging and developed markets is a recommended allocation. The idea is based on the theory that emerging markets have somehow ‘decoupled’ from developed markets. Emerging markets are supposedly growing rapidly regardless of recessions in developed markets. The reality is that they are closely correlated. A perfect match would yield a beta of 1. An ETF that tracks the MSCI Emerging Market Index has a beta of 1.14. Emerging markets track developed markets, but are more volatile. They outperform when the S&P is in a bull market and underperform during bear markets.

According to a recent theory commodities like oil, metals, or agriculture are supposed to be negatively correlated with markets. Such a negative correlation should make them ideal for asset allocation as a good hedge. Sadly this is not the case. Over some periods they are negatively correlated, but over the past three years booming equity markets have also meant booming commodities prices.

Alternative investments like hedge funds and private equity are another asset class that are supposed to be a good place to put your eggs. This strategy gained popularity among pension funds due to the success in the 1980s of a manager of the endowment of Yale, a prestigious American university. What may have worked then does not necessarily work now. As many as 89 per cent of hedge funds are below their 2006-2007 highs. It is difficult to value private equity except for the listed funds. Some famous ones like 3i has fallen 30 per cent and Blackstone has fallen 64 per cent since it was listed in 2007.

Markets are dynamic systems. Creating models based on past data which are validated only against that past data have limited validity. In science we can create the theories with general applications because the rules are consistent and inviolable. Markets do not have this luxury as long as governments continue to introduce chaos into a system constantly changed by financial innovation.

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