Spring Cleaning: Time to Throw Out Some Old Asset Allocation Advice
In times of sweeping changes in technology and culture, some products and services become exposed as being stale and unfit. Some conventional investment advice fits that bill: Like a musty old basement closet, some of it has just has not been refreshed for a long time.
One particularly contentious, and important, area entails the role of stocks in a portfolio. Don't get me wrong, I'm a huge fan of stocks. However, it really rankles me when the risk of stocks is misrepresented -- partly because it is not very high quality analysis, and partly because it does an enormous disservice to investors. And yet this happens all of the time.
Zvi Bodie (who also co-authored the investments text I used in business school) wrote an article a few years ago for the CFA Institute that addresses the issue. It is called "The long run risk of stock market investing: Is equity investing hazardous to your client's wealth?" [link] and should be required reading for anyone investing for themselves or for others.
According to Bodie, "The fallacy of time diversiﬁcation is very powerful. It is a basic fact in statistics that the standard deviation of an average gets smaller as the period over which the averaging occurs gets longer." He continues with a specific example, "For a one-year horizon, the probability of a shortfall would be 35 or 40 percent. For a 30-year horizon, it would be closer to 5 percent. A common misinterpretation of this observation is that the 'risk' has dropped from 40 percent to 5 percent." Such presentations are seductive because they deliver what investors want to hear: that "risk" is vanishingly small over the long run and therefore higher returns are quite accessible.
There is truth in this, but the problem is that it is not the whole truth. Bodie continues, "A common misinterpretation of this observation is that the "risk" has dropped from 40 percent to 5 percent. But the risk is not diminished. Something else is going on when the length of the time horizon increases: The worst possible outcome is becoming more possible. The tails are becoming fatter as the horizon lengthens, which means the potential severity of a crisis event is increasing."
This reveals the heart of the problem. An incorrect definition of risk and a naive understanding of statistics combine to form a narrative that is attractive, but wrong, or at very least, incomplete. Worse, it does so in a way that is very difficult to detect. Bodie concludes: "The notion that the longer the investment horizon, the more comfortable investors should be investing in equities is the foundation of most advice about asset allocation. But if this premise is fundamentally wrong (as I believe it is), then the advice most investment professionals are giving their clients is fundamentally ﬂawed."
Bodie's notion that long-term investments still entail considerable risk is not some kind of "fringe" theory either. In fact, it is mainstream thinking in other professions that contend with long time frames and the potential for extremely harmful outcomes. Engineers, for example, design long-lived infrastructure for 100 year events because they know that over a long enough period of time, some catastrophe is likely to strike.
What does this mean for investors? It means that investors often receive advice regarding portfolio construction that does not serve them well. It overstates a risk that doesn't matter very much (the dispersion of average returns) and understates a risk that matters a great deal (the chance of a material shortfall at retirement). In short, it offer the allure of higher returns by understating the true risks. This template for advice is absolutely not restricted to individual investors either; it is at least as prevalent among institutions.
An enormous positive in Bodie's analysis is that once the important risks are identified, they can be managed -- and he offers suggestions on how to do so. After massive returns on the stock market over the last six years, now is a great time to make sure your portfolio is as safe as you think it is.