THE DANGERS OF STRATEGIC ASSET ALLOCATION

Will the next bear market do to Asset Allocation what the Tax Reform Act of 1986 did to tax shelters? Will the individual investor continue to be “invested for the long-term” in the next bear market that is similar to the one in 1973-74? Do your clients truly understand that strategic asset allocation means never reducing their set allocation to equities, regardless of changing conditions in the investment environment and financial markets? Has your clients’ involvement in the financial markets been limited to the past 15 years? Do your clients fully appreciate that the investment returns during this period are not the norm?

First, some background. The argument for strategic asset allocation is that market timing does not work, and history tells us that market timing in fact has not worked. But tactical asset allocation, in combination with strategic asset allocation, is not market timing.

Market timing is all or nothing (100% stocks or 100% cash) limited to two asset classes, made on the basis of short-term technical analysis, and frequent adjustments. Tactical asset allocation, on the other hand, utilizes multiple asset classes and is based on long-term fundamental analysis. Adjustments are incremental and infrequent (e.g., an average in my shop of less than twice a year over the past 14 years).

The total investment experience of many individual investors, money managers and asset managers has been in the post-1982 secular bull market. This experience has taught them that market corrections and bear markets are short in duration and declines are not substantiated (excepting, perhaps, the short 1987 crash). This has led to the “buy on the dip” strategy, and investors are declaring that they are “investing for the long term.” It is easy to say that against the background of the 1982-98 secular bull market, but what happens if this current correction/bear market (and if not this bear market, then the next) turns into a 1973-74 type bear market that resulted in a 45% decline in the Standard & Poor 500 over 23 months?

Do your clients truly appreciate (or are they even aware of) the “bad” markets of the past? Some examples, in no particular order:

  • The market had an average annual return of 1.7% from 1929-49 and a 3% return from 1966 to 1982.
  • The Dow hit a record 735 in 1961 and was the same level in 1980 -no capital gain during 19 years.
  • The Dow lost 75% in real terms from 1968 to 1982; from 1929 to 1954, there was no return, with a 75% loss after inflation.
  • It took more than 20 years for a $10,000 investment in the Value Line index in 1966 to catch up with a $10,000 investment in a Treasury bill at the same time.

If - no, when - the next “bad” market period arrives, is it appropriate to advise your clients to “stay the course” and not adjust their asset allocation (other than rebalancing and adjusting for changes in their personal situation)? I am sure you are saying to yourself, we have discussed at length with our clients Modern Portfolio Theory, asset allocation as it relates to the trade-off between investment risk and investment return and the long-term nature of their investment horizon and strategic asset allocation. Nevertheless, in the back of their mind, do they really believe that when the next bear market arrives that you will in fact adjust their exposure to equities? Have you asked them lately? How would they react if their portfolio went down (for the first time) 25%, 35% or 45%? Would they expect you to do something? Would they expect you to actually “manage” their investments?

My firm’s approach to asset allocation involves a combination of the historical precedent of strategic asset allocation and the market insight of tactical asset allocation. This allows us to maintain a broadly diversified portfolio and to adjust the portfolio in light of changing market conditions. For example, for a long-term, moderate-risk client, we would set 65 percentage points strategically based on their risk profile and 35 percentage points tactically based on our forecast of the relative performance of the asset classes utilized over the next 12 to 18 months.

I have told our clients that the “buy on the dip” strategy will ultimately be the Achilles’ heel of the individual investor. Will blind adherence to strategic asset allocation that the financial planning profession has apparently taken, result in lost clients and lawsuits as a result of the next true bear market? Will the next bear market do to strategic asset allocation and the financial planning profession what the Tax Reform Act of 1986 did to limited partnerships and our profession?

Something to think about.

(This article was written by F. Dennis De Stefano and originally appeared in the February, 1999 issue of Financial Planning magazine.)