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 March 2006 The Worst of Both Worlds
Behavioral inclinations are almost impossible to overcome -- especially when many individual investors don't even recognize them in themselves. The Efficient Market Hypothesis supposes all investors always act rationally when in fact they rarely do. At the other end of the spectrum are those who reduce investing to a mechanical process. They set a specific asset allocation and then periodically rebalance their portfolios back to it. This eliminates the need for any ad hoc decisions and effectively removes any "human" element from the process. The asset allocators are typically more likely to be successful, but even the "behavioral" investors can prosper if they can counter their quirks and limitations. Once they recognize anomalies caused by human behavior, they're in a great position to take advantage of them. Investors who find themselves between these extremes are least likely to succeed. Oddly enough, some who should know better are guilty of encouraging this mistake.
Allocation Timing Writing in the December 21st edition of the Journal, Mr. Clements begins with the basic approach to asset allocation:
So far, so good. He even goes on to point out that Step 3, rebalancing, "isn't just about controlling risk. It can also boost returns, especially when rebalancing among stock-market sectors." Then things go haywire. "Fund categories usually don't soar one year and sink the next," writes Mr. Clements. "Rather, there tend to long spells of healthy gains and uninspiring results." As a result, he concludes that "If a market segment is bouncing back after a rotten stretch, don't rebalance every year. Instead, hold off rebalancing for two or three years, so you can capture more of the rebound." In other words, forget the rigor imposed by Step 3 and simply attempt to time the market. So much for the attempt to avoid behavioral biases. Sure, it would have been nice to let stocks run in the late 1990s rather than trim them each year in order to add more bonds. But what would have happened at the end of 2000? Would you have intuitively known it was finally time to rebalance back to the original target or would you have let it ride one more year, only to see your equity value -- and that of the total portfolio -- severely diminished? For many investors, it would have been better to sell a little stock each year rather than ride it all down in 2001 when the market broke.
When Worlds Collide Mr. Clements is correct, funds or even entire asset classes generally don't turn on a dime, but eventually they do reverse course. It's difficult, if not impossible, to determine when that will happen. Each time you delay rebalancing, you risk losing the modest benefits from prior years of dutiful asset allocation. Indeed, those who truly believe in asset allocation don't set out to blow away the market. Instead, they aim to beat it incrementally over time. A failure to rebalance in any given year can end up wiping out years of incremental gains. Is it worth the risk?
The benefits of asset allocation don't magically appear overnight. Instead, they accrue over the long-term. Arbitrary decisions not to rebalance on schedule are at best a form of market timing -- the very approach an asset allocation strategy is designed to avoid. It's human nature to want to do better than the other guy or outsmart the market. Unfortunately, most investors who take this tack end up in the role of the other guy. Don't' be one of them. It's unfortunate that someone like Jonathan Clements would fall into this trap, but hopefully now you know better. Asset allocation only works if you let it, and that means strictly adhering to your rebalancing policy. If you can't resist the temptation to periodically skip rebalancing, you may as well abandon the asset allocation process and develop a coherent market-timing approach. You are, after all, already engaged in it. 
 OOKING BACK OVER RECENT years, it's fairly obvious that money managers tend to post their best results relative to their benchmarks when their particular market segment is out of favor. In other words, it's much more difficult for managers to beat a highly performing benchmark.
We've pointed this out before, but it bears repeating: Active managers' best performance typically occurs when they don't do what they say they do. For example, the vast majority of actively managed mutual funds badly trailed their benchmarks in the late 1990s. While the S&P 500 was moving to new highs, actively managed funds were falling further and further behind. When the market as a whole is moving up, it takes an extremely astute stock-picker to come out on top. But that's not the case when stocks are falling. Stock-picking just isn't as important -- in fact, managers don't even have to own stocks to outperform, cash will do. As stocks lose value, cash (or bonds, or gold, or just about anything else) results in relative outperformance. That's why more managers manage to beat their benchmarks in bear markets. By not owning the stocks they're expected to invest in, they outperform the benchmark.
Putting This to Work Here's how it could work: First start off by dividing your portfolio into the asset classes you wish to use. It could be as simple as stocks, bonds, an cash, or involve more subtle divisions such as large cap value, small cap growth, and intermediate-term government bonds. It really doesn't make much difference how you divide it up, just as long as you have a clear idea of the specific asset classes to be employed. Next, take a step back and make an estimate of which classes you think will be the winners and losers over the coming quarters. Populate the anticipated laggards with actively managed funds since they're more likely to beat their benchmarks. Use index funds or exchange traded funds (ETFs) in those areas expected to outperform. Although index products probably won't beat the leading benchmarks, they typically won't fall as far behind as active managers will. Now the final step is to periodically review the model as market conditions change. When segment leadership begins to rotate, replace actively managed funds with index vehicles in classes expected to outperform and make the opposite trade for those that are expected to fall out of favor. We haven't run any numbers on this, but feel fairly confident that this strategy really ought to work. The opportunity for outperformance comes from the active managers' results in downtrodden sectors. The index products are only expected to keep pace with those that do well. Truth be told, just as active managers game the benchmark when their sectors decline, this games it, too, by relying on their success. Given that, is it accurate to say the model would beat a broad market benchmark? Arguably, it's as accurate as reporting more actively managed funds beat their benchmark in down markets. In the end, it really doesn't matter how you beat the market, just as long as you do. If the future's like the past, this cynical model has the potential to do just that. Now that's putting knowledge to work. Search this site! Just enter you key word or words:
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ARIOUS STUDIES SHOW THAT individuals are often poor investors. It's not because they're stupid or ill informed, but rather because they're humans. As such, they hold onto losing investments too long, hoping to avoid realizing a loss. They fall in love with certain investments while failing to notice superior alternatives. They're slow to adjust their expectations when actual earnings change so always over or underestimate results.
