Successful strategic asset allocation requires 3 key traits:
Key Trait #1: Ability to anticipate fundamental economic shifts
Globalization is the single most important tend driving change for investors today. However, most investors remain overly biased towards their home country, which has prevented them from seeing the opportunities and risks created by a rapidly changing global economy. Meanwhile, technology has provided a proliferation of tools, products, and strategies to break down the barriers and reduce the risks of investing globally.
The world is faced with several key imbalances that will drive economic fundamentals and market returns for decades to come. The effects of these imbalances, often magnified by policy responses, have significant implications for market returns of global equities and fixed income, currencies, and commodities.
At the trough of the financial crises in 2009, you could go back 40 years! and government bonds would have outperformed stocks. The secular market low of 1982, adjusted for inflation, brought us back to levels first seen in 1905. 77 years earlier! What you pay matters and stocks are not immune to that simple fact. There is no pre-determined rate of return.
Many investors steer clear of active asset allocation because it’s easy to paint with the “market timing” brush. Market timing, as it’s usually practiced, based on momentum and short-term fluctuations, is indeed a dangerous pursuit. As Graham and Dodd, the Grandfathers of Value Investing, explained
It is our view that stock market timing cannot be done with general success, unless the time to buy is related to an attractive price level, as measured by analytical standards. Similarly, the investor must take his cue to sell primarily not from so-called technical market signals but from an advance in the price level beyond a point justified by objective standards of value.
An active asset allocation approach requires understanding what drives valuations over cyclical market cycles (2-5 years) and secular market cycles (10-20 years). See my earlier post.Key Trait #3: Proper temperament to manage risk to achieve returns
Risk is perhaps one of the most widely misunderstood and difficult to measure concepts in finance. Financial theory has defined risk as standard deviation or the volatility of returns. While mathematically elegant, and computationally simple, this idea has serious limitations. Most investors, for example, do not think that the prospect of achieving returns that are 2 standard deviations ABOVE average is risky, where the opposite is clearly so.
Risk is a bit like pornography, “we know it when we see it.” or more accurately, we know it AFTER we see it.
Let’s define risk two ways:
1. The danger of permanent loss of capital, usually brought on by buying an asset with fundamental problems, paying too much for an asset, or using too much leverage to do so.
2. The likelihood that your portfolio will not produce the necessary returns to meet your liabilities, or at least your conservative, reasonable, goals.
Successfully managing risk #1, loss of capital, requires that investors possess, at minimum, key traits #1 and #2 above—the ability assess fundamental change and a keen sense of value—but it also requires the temperament and patience necessary to take advantage of that information.
It is largely the fluctuations which throw up bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them. -John Maynard Keynes
Being a contrarian requires having the courage to stand against the dominant view, being an independent thinker, and having firmness of character even when things get uncomfortable. For investment managers, it requires putting the profession ahead of the business, while being careful to work within a client’s comfort threshold. This requires that client and investment manager have aligned goals, shared values, trust and clear communication. Again, Keynes:
“…it is the long term investor…who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
Successfully managing risk #2 is about setting reasonable return targets, recognizing that available returns are a function of the opportunity set, not a function of the needs of the investor. Expect future posts from VRP on what sort of returns the market is priced to give us over the next 7-10 years (hint: it’s uninspiring at best)
When we enter and exit investments matters greatly to the long-term returns. Successful investors must have properly calibrated views of risk and the temperament necessary to add value over a static approach.