What No One Ever Told You About Your Asset Allocation Strategies

Computers are a wonderful tool. I must say that I am in awe of the breathtaking growth of raw computing power I have witnessed in my lifetime. And, I am amazed how they have been seamlessly integrated into mainstream society in such a short time. Without this computer power I cannot imagine how asset allocation strategies ~ computerized investment models ~ have also become so commonplace.

We seem to lose site of the assumptions that go into the creation of these models being so impressed with the graphic output they generate; and, somehow, unconsciously, attribute an impressive degree of validity to the output simply because they are computer generated. Computers do not make mistakes ~ do they?

Let’s look at some of the key assumptions that go into the generation of an asset allocation model. Data points, over 50 to 75 years, are captured on a variety of asset classes. The model averages all of the returns, correlations, and variances and generates a stationary data point for each of the inputs.
With this data an allocation is generated that suggests where an investor should place their assets to maximize their returns with the least amount of acceptable risk. Sounds like an ideal goal. Who would not want that? Yet there is an inherent disconnect that typically goes unnoticed. The key word in the previous paragraph is “stationary.”

The model assumes that future returns, correlations, and variances will be identical to these stationary inputs (from the average of 50 to 75 years of experience). Would you be surprised to learn that this has never happened? A computer generated, 75 year average statistical relationship may be an interesting starting point; but, constructing a model portfolio, never to be modified, may not help you over the next 10 or 20 years.

The next assumption is that bond funds equal bonds. I have yet to see an asset allocation model that does not suggest some portion of an investor’s portfolio be allotted to bonds. Yet, the menu of assets to fulfill this recommendation is typically Bond Funds. Bond funds offer diversification, professional research and management; but, they lack the one characteristic that actually makes a bond “safe.”

The key element that makes a bond “safe” is a stated maturity date. On a set date a bond owner is promised the return of ALL her money.  A Bond Fund never matures. Bond fund values fluctuate, inversely, with movements in interest rates because there is no maturity date. To suggest that an owner of a bond fund owns bonds is like telling a woman that she owns jewels because she owns shares of Tiffany & Company.

So, to the extent you are feeling complacent about your asset allocation strategies and complacent about your 401k advisors, you may do well to ponder these points.