After the market debacle triggered by the Great Recession, "Staying The Course No Longer Works," and "Modern Portfolio Theory is Dead," have been popular headlines with the financial media. It sure sounds good; after all, why would any investor willingly subject their portfolio to the massive losses of 2008 and early 2009? Of course no one would; so does that mean that long term strategic investing is out the window? One of the core beliefs at Evensky & Katz is that to earn market returns an investor needs to be in the market. Is that yesterday's story? Needless to say, our investment committee takes these questions very seriously and we regularly review our investment philosophy and strategies. What we've concluded is that a better headline for the critics of modern investment theory should be, "The Pot Of Gold At The End Of The Rainbow." Unfortunately no one has yet discovered that pot. Here's our take on the debate.
The critics claim that modern portfolio theory, asset allocation, and buy and hold are all equivalent concepts and all are passé. What surprises me is that the critics seem to believe they have just discovered the truth, when in reality a new group of "gurus" consistently discover the same truth after every bear market. These critics typically claim that "allocations are solely and simplistically based on projected historical data and traditional methodology that assumes valuation is irrelevant; they are determined at the beginning of the investment process and are never changed, except when they are rebalanced."
Although unfortunately it is true that many practitioners do in fact develop allocation models based simply on historical data, that is certainly not the case at Evensky & Katz. We heed the advice of Harry Markowitz, Nobel Laureate and the father of Modern Portfolio Theory. In his seminal work, Professor Markowitz wrote, "The first stage starts with observations and experience and ends with beliefs about the future performances of available securities." He is quite clear in rejecting the approach of using historical projections. "One suggestion as to tentative risk and return is to use observed risk and returnfor some period of the past...I believe that better methods, which take into account more information, can be found."
We certainly agree. When developing our recommendations for allocations to bonds and stock, we first develop forward looking estimates for the returns, risk, and relative movement (i.e., correlations) of the various investments we will consider for our portfolios. While there can be no guarantee that these estimates will turn out to be correct, they certainly take into consideration not only the past but also the current market environment as well as expectations regarding potential future changes. For example, our projections for future returns are modest relative to past returns, our expectations regarding risk is that the markets will remain more volatile than in the past and finally, we believe that we live in an increasingly global world, so markets will move more in tandem in the future than in the past. The result is that the benefits of diversification will be diminished but not eliminated.
The criticism is that allocations are determined at the beginning of the investment process and never changed, except when they are rebalanced. I call this "buy and forget." Again, it is unfortunately true that many practitioners do follow this ostrich-like policy; however, this criticism should be leveled at the practitioners setting their policies in stone. There is nothing in the literature or in practice to suggest that a policy allocation should not be revisited and revised when and if forward-looking market expectations change. As a consequence, it is our practice to review our
assumptions at least annually, and our "strategic" allocations do in fact vary over time as a result of changes in our worldview. Rather than "buy and forget," our policy is "buy and manage."
The bottom line is that practitioners may develop allocation models based solely on projections of historical data, but we do not. Practitioners may also ignore valuations; we do not. And practitioners may design allocation models and set them in stone; again, we do not.