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Asset Allocation Thinking and Consulting

The Internet and financial magazines and newsletters are bursting with commentary that tells readers to be X percent in stocks, Y in bonds and Z in cash—a premise that suffers from the misconception that all investors are alike.

By Jeffrey R. Kosnett, LAN Editor

OK, so the boldest spurts, or the most memorable investment calls, stem from hunches, gambles or manias. Earlier this year, despite some late setbacks, it was Internet stocks. Before that, it was computer-industry generals like Dell, Microsoft, and Sun Microsystems. Further back, such varied ideas as Japanese stocks, long-term zero-coupon bonds, emerging markets, takeover targets, bank shares, and global consumer growth companies (Coca-Cola, McDonald’s, et al.) have all had runs as the hottest, or at least the timeliest places, for retirement or college money. For brief periods, so have real estate and, if you recall the early 1980s, money-market mutual funds, which continued for a time to yield around 10 percent even after inflation eased beginning in 1982.

Everyone, whether investor or advisor, relishes the opportunity to tell the spouse or the kids or close friends about some spectacular investment. But let’s be honest. Millions of Americans aren’t comfortable bouncing their retirement or college money from place to place, hoping a few brilliancies will eventually change their life. Retirement savers’ horizons are long, and people who rely on an advisor or a financial planner tend not to be interested in a pattern of market-timing, sector rotation, or frequent trading to capture fast upticks, even if it’s easy enough to open an e-account and tempting to trade for $10 a pop. Even Merrill Lynch is joining that game. That doesn't make it suitable. Most 401(k) providers allow unlimited online trading. That doesn't make it suitable, either.

Seasoned planners believe investors are better off with a system, a plan, or a set of disciplines. This doesn't remove the challenge or the excitement. Entire asset classes, not just individual mutual funds or stocks, do not behave predictably. The best minds are not infallible. Warren Buffett’s reputation rests on his accumulation of equity in growth companies like American Express and Coke and Disney and watching the shares’ values multiply like rabbits. But even Buffett stumbles. He recently placed a big bet on Treasury bonds, expecting long-term interest rates to keep falling. Instead, rates are up and bonds have tanked in 1999. Shares of Berkshire Hathaway, Buffett’s holding company, have fallen 10 percent over the last year while the Standard & Poor’s 500 index is up more than 20 percent.

Any discussion between an investment client or prospect and an advisor sooner or later will turn to, “So what should we do with [all of or part of] this [long-term] money?”

“Invest it, obviously. We’ll work together…”

“But where?”

Back up. Tell me what kind of person you are. (The NASD frowns on not “knowing your customer” anyway.) What risks are you willing to take? How many years before you’ll need to spend the money? How much income will you need? Can you expect to contribute more along the way? What kind of a return do you think you can earn?

“I have this questionnaire and I use this [or several packages of] software so we can get started.”

This conversation, and in fact, this relationship, is headed directly towards the topic of asset allocation. If there’s one concept an advisor and a client must approach in harmony, AA is it. A confident advisor and a squeamish client, or an advisor who prefers active management but has a leave-it-alone minded customer, must agree that one party must change, both can meet in the middle, or else part company.

Asset allocation is not a 15-minute subject. It is the subject of countless books, software programs, academic papers, Web sites, off-the-cuff commentaries, and, make no mistake, shoddy shortcuts. The Internet and financial magazines and newsletters are bursting with commentary that tells readers to be X percent in stocks, Y in bonds and Z in cash—a premise that suffers from the misconception that all investors are alike. Stockbrokers, insurance companies, mutual fund firms, financial planners and consultants try to differentiate investors by questionnaires and by installing on Web sites free, interactiveasset allocation screens. These are well-intentioned, but the questions that ask the user to describe his or her style are often vague or multiple choice, which limits the scope of the output.

For example, this question, or one like it, appears in many places: You have an investment and it loses 10 percent of its value. Do you a) sell all of it, b) sell some, c) buy more, or d) sit tight?

The idea is to separate the patient investors from the mercurial and the risk-tolerant from the risk-averse, but if the respondent has no choice to qualify his or her answer, the exercise loses meaning. An investor with a diversified portfolio might respond in any of four ways, depending on which holding is involved: (a) or (b) for an emerging markets fund or a small-company stock with thin float that is getting hammered, but (c) or (d) if the 10 percent decline is in General Electric or an S&P 500 index fund, since investors generally can expect to do well over time buying more on the dips.

Clearly, no weighting can guarantee that every investor will be satisfied, or emerge after 20 or 30 years with a very strong return relative to risks taken. And, it’s timely to add, with the bull market now old enough to drive, the new tendency for stocks and bonds to move in lockstep rather than to offset one another’s movements, and the ease and efficiency of indexing, the very idea of asset allocation is under some pressure. But does it still make sense? Absolutely.

What’s it all about?
The concept is simple. You take investment capital and, depending on variables like net worth, time frame, risk acceptance, and other assets the investor owns (pensions, real estate, likely inheritances), decide the appropriate places where it should go. Asset allocation operates on several levels. The top is strategy—how much of each dollar goes to stocks, bonds, liquid savings accounts, etc., usually based on a pyramid or a “baskets” approach to the degree of risk inherent in each asset class. Then comes tactics—the deployment of the money within these divisions. For example, in stocks, there are growth, value, blue-chip, micro-cap, international, high-dividend, etc., while in bonds there is a range of duration and credit quality. Then comes the issue of whether to put some money in asset classes with a low correlation to stocks and bonds, to counter the effects of sudden losses. Real estate is a candidate for this job, since real estate often succeeds as an inflation hedge, while rising inflation is poisonous to long-term bonds and, consequently, bad for most stocks.

Financial planners say most everyone they advise, regardless of experience, grasps this much. The elementary catchphrase, “Don’t put all your eggs in one basket,” commonly refers to savings and investments. Most people who belong to retirement plans top-heavy with their company’s stock, or have 401(k) and 403(b) savings plans that offer access to only a few separate accounts, have learned to feel uneasy about the concentration.

However, as simple as the concept seems, finance experts do study asset allocation to an amazingly analytical degree. Some of the top academic stars in finance, such as Roger Ibbotson of Ibbotson Associates (see sidebar on page 50) have published books and papers based on intense mathematics which they use to figure what percentage of an investor’s return is explained by allocation, as opposed to the specific stocks, mutual funds, etc. or the timing of investment inflows and outflows. Several Nobel Prizes in economics recognize research into the effects of allocation and diversification on portfolio volatility and return. Analysts who use the historical data almost always conclude that diversification reduces volatility and limits the risk of severe losses more than it holds down long-term returns.

Perhaps the best-known, or the most-often referenced, academic work on asset allocation is the “Brinson study,” by several researchers led by Gary Brinson, a money manager who in the 1980s concluded after analyzing a bunch of pension fund reports that a whopping 90 percent or more of the variability of a portfolio’s performance over time derives from its asset allocation policy. That means, unless you have a short-term trader’s horizon, deciding how much goes into which asset classes (small or large stocks, long or intermediate-term bonds, or what-ever) is significantly more important than choosing the specific names beneath these asset weightings. This seems counter-intuitive in an age when those who bought and kept buying and held onto Intel and Microsoft (or mutual funds overweighted in these kinds of holdings) have made astronomical real returns, while investors partial to the likes of Sears and USX are so far behind you could say their portfolios are lost in tall grass.

The Brinson study, which has been misinterpreted to say that stock or fund selection is totally meaningless (in the short run it absolutely isn’t), has its academic detractors, and this story is not about academics’ views. But, suffice it to say, there is literature about asset allocation understandable and accessible enough for just about any advisor or client to learn more than the bare essentials. (See sidebar on page 54). And virtually all investment and insurance companies either produce or distribute custom asset allocation software so reps and clients can not only see the value of creating a sensible allocation, but can use the programs to suggest reasonable weightings consistent with the client’s personality.

The idea is, given enough time and absent hasty investor overreaction to market moves or news events, a sensible asset allocation can take some of the uncertainty out of investing for retirement, education, or other goals.

Perhaps the downside of such a discipline, especially if a computer governs it, is that it can seem to turn investing into a mechanical exercise, taking all the fun out of what to some people is a participatory sport. But, says Jim Mangan of John Hancock, an expert on asset allocation and on Hancock’s new Portfolio Planner II software, developed for Hancock reps by Ibbotson Associates, that’s not true. “This is not a straitjacket, it’s a framework.”

“It’s not mechanical, but a way to frame the conversation and move the process along. You put specific models on the table based on sound methodology. We use Ibbotson data for both the questionnaire scoring and the model portfolios, but you can really open up a dialogue from there rather than closing it up and making it mechanical. To go from asset allocation to the investment decision requires a great deal of conversation that makes the decision of individual fund choices relevant.”

Financial planners and investment advisors say they are generally eager to have these conversations, not just to turn on the computer and passively fill an investor’s requests. Planners, after all, need to add value to justify their fees and must have something to say when the client arrives for a quarterly, semi-annual or annual meeting of the minds. Here’s how a few experienced planners think and work:

Thoughts from the field
Kyle Atkins, CLU, ChFC, of Atkins & Associates in Spartanburg, S.C., sounds typical of the way financial planners and clients arrive at the allocation. At the beginning, the client doesn’t have more than a cursory understanding—just the eggs-and-baskets sense. After a while, the investor begins and then more fully understands the points of patience and diversification. "Going in, the client generally does not have much knowledge at all, but as we spend enough time in consultation, they get a lot better feel," Atkins says.

Atkins starts with a questionnaire about the client’s finances and expectations, but his isn’t as deep and specific as some others use. I generally do not like to confuse the client with way too many questions or too much in-depth probing so we usually just do some generalized questions.

“Then we use software and look at the asset allocation. The software gets very specific class-wise but not for a particular investment, mutual fund, or whatever.” Atkins uses an allocation program called Wilson Power Optimizer, which, based on the investor’s inputs from the questionnaire, usually ends up suggesting a portfolio spread among seven or eight classes within equities—large-, mid- and small-cap value and growth, international, plus growth-and-income and equity-income—pretty much the whole “style box” of funds. Do the investors know what all these mean? “They do once I get through with them,” Atkins declares. His clients are usually invested 60 to 70 percent in equities, with current positions a little higher than that on average. When they come in, they are often “under-allocated,” meaning too much cash and not enough stocks, and Atkins finds his recommendations, based on the computer analysis, not only correct this but reposition the types of funds so the portfolio’s elements do not all behave identically during times of unusual market volatility.

He does not act like a professor as he consults, though. “We miss the point if we try to over-teach.” The most important thing is making sure [clients] are at least in and diversified and have a degree of faith in the efficiency of the market itself.

“The most important thing for the client is to be doing it, not thinking about it. If you give a client way too much information they think about it six months or a year and you’ve defeated the whole purpose of trying to get them to plan.”

Michael Stephens, CLU, CFP, of Stephens Financial and Insurance Services in Saratoga, Calif., starts client relationships by preparing investors for swings “more to the downside than the upside.” He never projects greater than 10 percent annual gains, although some software incorporates larger compound annualized returns since the allocation algorithms can be based on extended bull market results, and he encourages clients to call if they are worried or puzzled about market moves. It turns out they rarely ask him. They stick to the plan.

When Stephens conducts his semi-annual in-person client reviews, a key part of the review is to break down the portfolio at that point into asset classes, including the sub-classes of equities like large, medium and small growth and value. He often recommends rebalancing, something perhaps a majority of annuity investors elect and that some financial planners believe in strongly but others dislike, preferring instead to let momentum take its course.

Stephens’ recommendation on whether to rebalance the portfolio (by selling some appreciated holdings to restore the original relative asset mix) can depend on whether the money is in a qualified or a non-qualified account. In a taxable account, Stephens says, he might just move dividends around, while in a tax-deferred account, he is more willing to rebalance the full portfolio.

Charlie Harrison, a financial planner and life insurance agent with Sunesis Financial Services in Pontiac, Mich., is even more locked into letting the plan—and the software—call the shots.

“What has happened is that institutional investors used asset allocation software for years, and now it has trickled down to individuals,” Harrison says. He feels investors, or at least the people he serves, too often “try to chase the market” and that adhering to an allocation, such as those he gets from the Touchstone ProRep program he uses, protects them.

“If the market gets away from us,” Harrison says, “it tends to come back.” The software’s output is a backup that helps him explain to clients why their money is invested as it is and how this mix is suitable for their long-term goals and objectives. Only major life changes, and the client’s annual review, can get in the way.

Room for a view?
Charlie Harrison says he doesn’t have a current feeling about the markets, just that it makes no sense to him to chase after big increases. But, at a Dow Jones industrial average of 11,000, with price-earnings multiples high and dividend yields low, and with both short and long-term interest rates looking to go up again and again before they fall, shouldn’t an advisor wonder if stock prices are overhanging? Or if not, why not?

Isn’t it part of any advisor’s job to take a position and tell clients to consider changing their asset mix to include more cash, or more of something and less of something else? Do advisors who use asset allocation programs that point to 20-year trendlines have room to take a view?

Forecasting seems unpopular with many planners, who say their clients aren’t interested in daily or weekly balances and, moreover, are not at all interested in discussing if their advisor is bullish, bearish, or in between. But this is not a unanimous opinion. There are some planners who believe in being more involved and more often.

“Asset allocation is very important,” says Gary Ruchin, CLU, ChFC, CFP, of Ruchin & Associates, a “financial engineering” practice in Vernon, Conn., “but once we do that, then we see if the clients feels comfortable with this. If they don’t feel comfortable, it can be the best allocation model in the world, but I’m not going to sell it to them. I’m not going to set it up.”

Ruchin requires clients to meet with him quarterly, not every six months or once a year, because he wants to explain losses sooner rather than later. While some planners profess to tune out financial news events and statistical releases that account for market moves or reverse trends, Ruchin knows when the GDP numbers are due and, of course, when the Federal Reserve Board is poised to act.

His clients, like Atkins’ and Stephens’, have a large majority of their portfolios in equities: and at any age. He says people who are 65 now will outlive their money if it is largely in fixed-income today (something many software packages recommend) and so he tells them to keep on pursuing growth because “I am having more clients celebrate their 80th birthday than their 65th.”

For older people, Ruchin may put in some bonds or recommend a fixed immediate annuity, but he says it’s possible, using the data available, to construct a growth-oriented portfolio of low-beta, high R-squared (less volatile but strong performing) stock mutual funds suitable for aged clients. His favorite software—Morningstar’s Principia—produces three-page portfolio reports that do not overwhelm investors. Instead, the clients learn about and get fascinated with elements of asset allocation and portfolio theory like standard deviation and Sharpe ratios and take a more active interest in the recommendations.

Ruchin concedes that all investors aren’t misbehaving if they trade outside the program with part of their money. While he dislikes e-trading, he says, “I have clients who actually do that sort of stuff with some of their portfolio. And that’s fine. Then they come in and we look at the Morningstar and their stock is down 50 and [my recommendations] are up 18”.

“But that’s OK. They’re playing with a little bit. That’s fine. They’re happy. They leave the majority of the stuff with me to make joint decisions. The reality is, most people cannot be objective with their money. Usually, when you discuss things with other people, you make better decisions.”

Does it really matter?
If advisors disagree on whether to let the allocation program manage the relationship, or instead just to use its recommendations as a starting point, perhaps the answer lies in whether asset allocation itself remains a timely practice. Or has it seen its day?

The “eggs in many baskets” thinking holds up best when it is clear one can diversify away from risks. When mutual fund companies introduced global funds in the U.S. in the 1970s and 1980s, they promoted them with graphics showing that in most years, or over most five-year periods, there are sharp divergences between U.S. markets and other major countries’ indexes.

But now, information spreads so fast, and economies are so inter-related, that whenever U.S. stocks tumble, European and sometimes Asian investors also sell off and the news reports spread the idea there is a direct connection. (The same is true with rallies; European markets have also hit record highs in recent years.) This thinking makes sense, given how so many “American” companies make a large part of their sales and earnings abroad and how such “European” companies as Siemens and DaimlerChrysler are more accurately described as stateless enterprises. If the Federal Reserve were to go forward with unexpected interest rate boosts, British, French, German, and Japanese markets would also be pounded even if their central banks didn’t also tighten.

Prices of U.S. stocks and bonds, to take another example, once moved in opposite directions. As the American economy grew steadily in the 1950s, long-term interest rates crept higher to the point where seasoned Treasury bonds lost significant value. But stocks kept appreciating anyway as corporate America dominated the world and leading industrial companies kept boosting dividends, which were more important to investors in those days than they are today. Today, the biggest threat to stock values seems to be rising interest rates or just the expectation of rising rates. Analysts question how stocks can keep climbing if rates are no longer at or near their lows. The correlation, therefore, between blue-chip American stocks and Treasury bond prices has become much closer.

This suggests that at some point, the traditional diversified portfolio of stocks, bonds, and Treasury bills may no longer smooth out overall volatility as well as the theory says it should—and so there will be more pressure on investors to pick the right stocks (or sectors) and the best mutual funds and annuity separate accounts. Software programs that supply many planners’ and investors’ broad asset allocations may prove to be less valuable without more interpretive personal counseling and better-informed clients. Only the professional portfolio managers’ packages, which cost many thousands of dollars a year, go into this detail. And stock-picking and mutual fund selection, despite the market’s efficiency and the amazing fund databases (check out as well as the Morningstar products), remains an art, not a science.

But, then again, it’s sometimes fashionable to say that old financial rules are dead. For example, a company can see its stock soar even if it makes no profits, as with so many Internet companies. Then something goes wrong and everyone learns that, yes, everyone, the rules are still in force.

So it would be premature to say asset allocation is over the hill. It’s just the nature of the assets that changes—and the ways advisors can keep investors informed.

I/R Code: 4000.00 Investments 4000.14 Portfolio Management


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