As explained in the first paragraph, asset class diversification as is currently applied with false conventional wisdom failed in this environment, just when investors needed it the most.

Some might consider the current market environment to be an “outlier”…a Black Swan if you will.  Besides, prior to this outlier market, this sophisticated allocation produced high risk adjusted returns. Then again, that was in the past. Prior to this outlier event, this allocation might have outperformed by 2% over the last ten years. Even over the last thirty years it might have outperformed by 1%. Well, you had better hope that happens in the future because you NEED it to be right for the next 15 to 30 years just to make up for the risk of this supposedly more diversified, sophisticated portfolio (see Figure 3).

Figure 3 – Boring balanced portfolio growth of $100, AFTER the last year’s losses versus a “sophisticated” balanced portfolio and how long it will take to make up for the risk just experienced with 1% out-performance and 2% out-performance for the next 15-30 years:

Figure 3 shows you that if you started a year ago with $100 invested in the boring balanced allocation, a year later it would be worth $78.52. The “sophisticated” balanced allocation would have declined to $59.83. If one assumes an 8% return for the boring balanced allocation going forward, how long will it take to make up for the risk experienced over the last year with the sophisticated allocation if it outperforms by 1% (a 9% assumed return)? Maybe that sophisticated allocation will out perform by 2% (a 10% assumed return) and if it does, it will take fifteen years to make up for the risk just experienced.
 
Can your allocation outperform by 2% a year, net of all the extra expenses? It had better do so for the next 15 years to make up for the risk you just experienced. If it only adds 1%, you better hope there isn’t another devastating market anytime in the next 30 years because it will take you another 30 years to make it up.

Of course, in real wealth management plans, there are cash flows like savings and retirement income, which is what we manage. Subjecting clients to the asset allocation bets like the balanced allocation shown in Figure 2 is a risk real wealth managers avoid because wealth management plans with cash flows cannot afford to make such gambles of whether the money will be there when needed.

Simple and low cost is a safer route than expensive and theoretically sophisticated. Jettison the sizzle and focus on goals. Avoiding needless risk lets you make the most of your life and your clients’ lives.

*Indices used:
 

A popular industry speaker and writer, David B. Loeper is the CEO and founder of Financeware, Inc. in Richmond, VA,. He is author of the top selling book Stop the 401(k) Rip-off!, three other books being released in 2009 by John Wiley & Sons (Stop the Retirement Rip-off, Stop the Investing Rip-off and The Four Pillars of Retirement Plans) and numerous whitepapers. Hehas appeared on CNBC and Bloomberg TV, served on the Investment Advisory Committee of the $30 billion Virginia Retirement System, and was chairman of the Advisory Council for the Investment Management Consultants Association (IMCA). Before founding Financeware in 1999 he was Managing Director of Strategic Planning for Wheat First Union. He earned the CIMA® designation (Certified Investment Management Analyst) from Wharton Business School in 1990 in conjunction with IMCA.

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