Dear investor, provided your head has stopped spinning from these tortuous few months, let's talk for a bit about asset allocation. You know, adjusting the holdings in your 401(k), Individual Retirement Account, or personal portfolio so you don't end up with all your money in the same place at the same time. As you also know, you're supposed to keep rebalancing that portfolio according to your age, goals, and tolerance for risk.
You may have noticed where the conventional wisdom has gotten you over the summer: in a hole. Large-cap stocks, small-cap growth stocks, high-yield bonds, private equity—they've all traded in the same direction. Down. So much for a balanced portfolio. All it has bought you is an evenly distributed plunge—good for Olympic divers, bad for you.
You may take solace from the big bounceback after the Fed's recent rate cut. But the real salve, of course, won't come from daily or monthly movements. It will come from performance over the long term. When clients complain to financial adviser Charles Massimo of CJM Fiscal Management in Garden City, N.Y., about the markets, he tells them "to ignore the noise."
Yeah, right. There's a reason these gyrations are so hard to ignore. The idea behind asset allocation is to have investments with little or no correlation—they're not doing the same thing at the same time. But when investors get spooked, they sell indiscriminately, and the correlations jump. It happened in 1987, in 1990, in 1998, and again this summer. "History shows that, in the short term, correlations often spike in times of trouble," says Marc Stern, chief investment officer at Bessemer Trust in New York.
To really see what's happening, look under the hood. The most recent Journal of Financial Planning shows that correlations among asset classes—the underpinning of any allocation strategy—are more changeable than we're led to believe. William J. CoakerII, senior investment officer for equities for the San Francisco City & County Retirement System, researched the correlations for 18 asset classes for the 1970-2004 period. U.S. stocks (the Standard & Poor's 500-stock index) and bonds (U.S. investment-grade issues) have a 0.23 correlation, which means that only 23% of the time are bonds and stocks acting the same way. But remember, that's an average, and the actual correlations range from 0.31 to 0.77. (A negative correlation means two assets move in opposite directions.)
What's more, Coaker showed in a previous article that correlations don't just bounce around but sometimes change their behavior. From 1970 through 1998, international stocks had 0.48 correlation with U.S. stocks. "But from 1998 to 2002, it rose to 0.83," he writes. These relationships are "inherently unstable."
If correlations are volatile, does it make sense to keep your allocations constant? Most advisers would say yes. But not all. Elliot Fineman, a senior vice-president at Compass Investors, a Kenilworth (Ill.) money manager, compares conventional asset allocation to driving at a constant speed, regardless of traffic and road conditions. "You'd have a serious accident," says Fineman. Compass issues asset allocation recommendations every five weeks based on a model that crunches economic and market indicators.
An even more radical approach: Put 85% to 95% of your money in an ultra-safe asset like U.S. Treasury bills or inflation-indexed bonds, and put the rest in speculative, leveraged bets. That's the sort of approach advocated by Boston University finance professor Zvi Bodie (BW—Sept. 10) and by hedge fund manager Nassim Nicholas Taleb in his best seller The Black Swan: The Impact of the Highly Improbable. It minimizes damage from an ugly downturn while maintaining some upside.
Does this mean asset allocation doesn't work? Not at all. But it may work better in some periods than others. If that seems like too much risk, you may want to consider one of the alternatives.
By Brian Hindo