June 2008 |
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In the investment management industry, "passive asset allocation" has come to rule the day. Its emphasis cannot be overstated and its affect on investors, both professionals and individuals, is far reaching. However, it might be that in certain kinds of markets, asset allocation isn't all it is cracked up to be.
Instead, "active risk allocation" presents a more robust way of growing (and protecting) your investment savings along the way.
Asset allocation is about deciding how many of your investment dollars will be "allocated" to stocks, bonds or cash. Of course, academics and professionals often try to make this seem far more complicated than it really is, but essentially an asset allocation plan is simply choosing how much of your money your are going to put into which bucket and sticking to it.
An often quoted and still dominant thought is that 90% of an investor's stock market return comes not from which particular stocks they choose but from having just chosen to own stocks to begin with. Studies by Gary Brinson in 1986 and Roger Ibbotsen in 2000 concluded that active managers, those who seek to better the market, were mostly unsuccessful when compared with those who just passively took what the market was giving them. Further, the concept states that the return an investor gets from a balanced portfolio of stocks, bonds and cash is mostly explained by how much they have in each of those buckets. With this academic ammunition, index fund investing and other basic, passive asset allocation strategies flourished in the investment advisory industry.
We know it takes a lot of chutzpa to argue with millions of people, and let us be clear, we don't discard the concept of asset allocation out of hand. Our argument is that asset allocation, in the type of market we've been in and may be in for some time to come, isn't the answer it used to be. In our opinion, the most recent bull market period from 1982 to 2000 has, kind of, warped the mind of investors. The long run period of 18 years has basically lulled the average observer into thinking that double-digit annual returns are normal and to be expected going forward. In a bull market, we totally agree that asset allocation is a very valid strategy. Trying to beat the passive returns achieved from 1982-2000 is fruitless and frankly not really worth all the effort it takes. However, we think the environment has changed and the movement away from passive asset allocation is timely.
Since the high set in early 2000, now 8 years ago, the U.S. stock market has produced a disappointing 1% per year. After inflation, this means that investors who passively owned the biggest stocks in the US have actually lost purchasing power on their savings. Granted, after 2003, the market has recovered some, but the ups and downs since 2000 has resulted in no returns for passive stock market investors.
One would think that after eight years of a "sideways market", stocks would be poised to shine again. Before jumping to conclusions, it is important to review exactly how investors make money in stocks. The two key drivers of stock market returns are the dividends you get plus the appreciation in the value of stocks themselves. The first driver, dividends, are yours to keep and the second driver, generally rising stock prices, is only there if the market decides to give it to you. It is deceptively simple.
Today, even after the market has stagnated over nearly the past decade, the dividend yield still rests at just under 2%. As a point of comparison, back in 1982 the dividend yield started out at 5.5%. The second driver, the appreciation of stock prices, has to be further broken into two parts. The first part is the underlying growth in earnings of the companies themselves and the second part is the chosen price-to-earnings multiple that investors place on those earnings. Think of that price-to-earnings multiple as the market's "mood factor". Again, back in 1982, the economic backdrop was quite depressed and the mood factor was therefore very, very low. By 2000, at the market's peak, the mood was euphoric.
So, basically the total return for investors in stocks comes from dividends, earnings growth and the mood factor. Over time, especially for long-term investors, the 'mood factor' should even itself out and provide no added kicker nor should it detract from returns. That means, in a normal world, investors should expect to get the dividends and be rewarded for the growth in earnings. If all was normal, that should work out to about 2% from the dividends plus about 6% in normal earnings growth or a total return of 8%. We wish this were true, even it is less than the 18% annual returns from that wonderful 1982-2000 bull market.
However, we argue that things are not "normal" and it all has to do with the growth in earnings and the mood factor. We feel that earnings have gotten ahead of themselves over the past five years or so. As a percentage of our nation's Gross Domestic Product, corporations normally earn about 20%-30% less profit than they are earning today. Granted, it is not across all industries, but taken as a whole, we argue that earnings are actually higher than what Economics 101 would expect. This is only partially explainable by global trends but regardless of the reasons, we firmly believe that all "excess profit margins" will be eaten down by competition over time and today's phenomenon of higher than normal profit margins will not defy the laws of competitive destruction for long. Please understand, we expect earnings will grow over the years, but probably by less than the historic 6% rate over the next five to ten years. If we're right, earnings growth may only give us 2% per year over the next five to ten years.
This leaves investors to ponder the following. Considering that the mood factor is far more normal today than it was in 1982 - very unlike what it was at the start of last long-run bull market in 1982 - we see an environment where dividends will kick in 2% and earnings growth might only add another 2%. With these entirely plausible assumptions, we may be entering a period where passive "asset allocating" investors should expect only 4% or so in total return. Passive asset allocation strategies, in the kind of market we foresee, will simply not make as much sense as it did in decades past. On the other hand, a new kind of strategy, called risk allocation, will have strong appeal.
Think of risk allocating as not divvying up your assets into investment buckets, like stocks, bonds and cash, but instead divvying up your assets into risk buckets (high, medium or low). Higher risk buckets ought to produce higher returns, which is common sense and lower risk buckets ought to produce safety and predictability. The price paid in the lower risk buckets are lower returns, of course.
In a bull market, a healthy allocation to the higher risk bucket - that is, investing in stocks - was rewarded by higher returns. In today's environment, that risk allocation won't necessarily be rewarded by a passive asset allocation strategy. At times, it will be quite prudent to park a portion of your allowance of "higher risk dollars" into bonds or even just cash. At other times, stocks might re-assume their status as deserving a heavier portion of your risk allocation.
This dynamic process of active risk allocation turns the tables on the old asset allocation crutch that so many have relied upon. There is no question that it is far easier to be able to passively make money than it is to actively scratch out returns, but sometimes you have to play the cards you've been dealt. The key is knowing the card game that's being played when you choose to sit down at the table.