The Dirty Little Secret of Efficient Frontiers

Daniel Sotiroff highlights a key point about strategic asset allocation:

The primary task in asset allocation strategy is to determine how much of a given asset should be included in a portfolio. Various combinations of different assets can and should be considered. For instance, the historic returns and volatility of US large company stocks and Treasury Notes can be combined in various proportions and charted in the following way.

ef1

The chart above is commonly referred to as the efficient frontier. In theory it shows the maximum return that was achieved for a given level of volatility (sometimes referred to as risk). A word of caution is required when working with models such as these. It would appear to be easy to optimize a portfolio around a precise rate of return and volatility. However, the chart above was generated using historic returns data and the future is unlikely to look like the past. Rates of return, volatility and correlation coefficients can all change over time. Using past data to forecast an ideal optimal allocation for the future can be disastrous. Here’s what the efficient frontier looks like decade-by-decade.

ef2

My emphasis added.  Every time I see this type of analysis, I think of the following image:

reality

Source: Twitter, @ThinkingIP

It is easy for a novice to look at an efficient frontier of stocks and bonds, constructed from long-term returns, correlations, and volatilities, see the associated return and risk of different combinations and come to the incorrect conclusion that achieving their financial goals will be a smooth ride.  It won’t.  Reality is full of peaks and valleys, extended bull and bear markets in different asset classes.  A strategic asset allocation is highly unlikely to give you an optimal allocation for every decade.  If a typical investor has 3 or maybe 4 decades that will largely comprise their personal investment time horizon, then a fairly static asset allocation may leave them wanting and may leave them well short of achieving their financial goals.

Is Tactical Asset Allocation the solution?  I think it can be an effective way to deal with the significant variability in asset class behavior from one decade to the next.  Is Tactical Allocation perfect?  Certainly not.  Furthermore, there are a million different flavors of Tactical Asset Allocation and many of the flavors that I have seen probably will underperform a strategic asset allocation.  Based on my experience and the experience/testing of Dorsey Wright, I am inclined to think that a disciplined relative strength-driven approach to Tactical Asset Allocation is likely to do very well over time.  Click here to read a white paper by John Lewis on how this might be accomplished.

Click here for important disclosures.  The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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