Investing
The Right Tools
A decades-old investing theory still has value in today's investing toolbox, but beware of some potential problems.
FROM: MAR-APR 2003 ISSUE | BY LARRY SHORT
Previous "Investing" columns have discussed how you can use asset allocation to lower risk, and indeed, how it may be the single best investing method for the next 20 years. Like any tool, however, you must use this method with skill.
You may have encountered this method when opening a mutual fund or investment account. If you answered a series of questions about your personal situation, wealth and risk tolerance, you were likely testing your taste for asset allocation. Problems start to become apparent when you realize that there are many asset allocation programs, forms and procedures in use by institutions throughout Canada. Which of them is best?
There is essentially a set of asset allocation tools, and like any set of tools, some are more useful than others. To know and understand the differences in asset allocation strategies and select the right one, you must be aware of the pitfalls that can blunt this tool's application.
Theoretical Tool
Arguably, the history of modern asset allocation theory can be traced to 1952 and the work of Professor Harry Markowitz. His innovative, practical theory earned him the 1990 Nobel Prize in Economic Sciences 38 years later. Markowitz's work involved plotting the historical returns earned by various combinations of stocks, bonds and cash versus the risk of each combination over time. This resulted in an egg-shaped pattern that tended to indicate that the larger the proportion of your investment that is placed in stocks, the higher your potential return.
But the breakthrough came when Markowitz realized that the pattern revealed some other features. Markowitz's key finding was that the rate of return did not increase exactly in proportion with the amount invested in stocks — neither did risk. But there are a series of unique investment combinations that offer investors the highest expected return for any given risk level, or the lowest risk level for any given expected return. This relationship when plotted graphically is called the efficient frontier.
Another interesting feature of Markowitz's findings is that, although risk generally decreases with more bonds held in your portfolio, there are combinations of stocks, bonds and cash that actually carry a lower risk than investing in bonds alone.
However, when you move from theory to practical application, problems often arise — as they do here.
Faulty Tools
The model that Markowitz developed was designed for institutions, notably pension funds, mutual funds and insurance companies. These interests have an infinite investing period, and the model has worked well for these groups over time.
Of course, the investment horizon for an individual is not infinite. Individuals are planning for a fixed time, such as retirement or their children's education. Consequently, the allocation output determined by the model may skew the results to suggest that the investor take on more risk than was intended.
There is a relatively easy way to test your allocation software and determine whether this flaw exists. Submit your input information twice, keeping all factors equal except for the investment horizon question. You will get two sets of results; a comparison of these results will indicate if the software takes into account a shortened investment horizon, and if so, to what degree. For example, the results for someone who needs their money back in one year should show a much more conservative proposal than those for someone who will invest for 10 years.
There is another potential problem in that the Markowitz model assumes risk is equal over the entire, infinite investment period. However, consider this: since the beginning of 1998, there has been at least one low-risk point in the market — August 1, 1998, when the TSE was at 5,530 — and one high-riskpoint — September 1, 2000, when the TSE hit 11,388.
If you'd been asked to complete an asset allocation survey at each of these two points, your results would have been identical. That is, you would have put the same proportion of your savings into stocks, bonds and cash whether at the bottom of the market or the top. Does that seem rational? Shouldn't you have two completely different results? Shouldn't you be putting more money into bonds and less into stocks as the markets rise, and vice versa?
Unfortunately, Markowitz's model wasn't built to take into account such short-term moves. So should you follow the model blindly, or is it better to correct for what seem to be obvious errors?
Strategy Repair
Obviously, it would be better to correct potential errors. You must first determine if your asset allocation software takes into account your real investment time horizon. If it does, all is well and good. If not, one simple way to adjust is to take only the equity portion of the suggested portfolio and reallocate it using the same portfolio recommendations from the asset allocation software. For example, if your asset allocation suggests 60 per cent stocks, 30 per cent bonds and 10 per cent cash, take the stock portion (in this case, 60 per cent) and reapply only that portion to the same allocation. The end result would be 36 per cent stocks (60 per cent of the output above), 48 per cent bonds (30 per cent of the 60 per cent added to the original 30 per cent above) and 16 per cent cash (10 per cent of the 60 per cent added to the original 10 per cent above).
But this adjustment may have a detrimental impact on your investment plan. Because it will exaggerate the amount of money you have in bonds, it may lower your long-term rate of return. On the other hand, the strategy should sufficiently lower your real risk in the market, making for less worry while still earning a reasonable return.
Once you've determined the proper allocation proportions, you must adjust for the risk level in the market. This is by far the most difficult modification. In fact, the reason that the asset allocation method was invented was to eliminate the need for market timing. To counter this difficulty, you can make a number of small adjustments over time.
One such minor adjustment is to use the level of optimism in the market as a counter indicator of investment strategy. When returns are positive and markets are approaching old highs, you should consider becoming more conservative; when markets are low and the financial headlines are depressing, consider becoming more aggressive. This is actually more difficult than it sounds. It is highly subjective and depends on your experience and judgment, or that of your adviser.
An alternative to this kind of conjecture is to determine what your long-term rate of return has to be to meet your investment objectives, then use that figure as your baseline. If that rate of return were eight per cent, for example, anytime your account earned more than eight per cent in the previous quarter, you should consider becoming more conservative, and vice versa.
Use Tools Wisely
It is apparent that asset allocation is a powerful tool, but you should be aware of its shortcomings and attempt to modify it for your specific investment goals. And, as always, be mindful of who assists you in its use, taking into account the experience and knowledge of your adviser. In the right hands, asset allocation can be cutting edge. Misapplied, it will cut you off at the knees. Use this tool wisely.
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Larry Short, B.Comm., CIM, CFP, FCSI, CGA, is a Senior Investment Adviser with TD Waterhouse Investment Advice* in St. John's and is author of In Short: Secrets to Make Your Dollars Grow.