Staying the Course No Longer Works?

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” discovers 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 my firm. 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 return for some period of the past…I believe that better methods, which take into account more information, can be found.”

I certainly agree. When developing my recommendations for allocations to bonds and stock, I first develop forward-looking estimates for the returns, risk, and relative movement (i.e., correlations) of the various investments I will consider for 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 future changes. For example, my projections for future returns are modest relative to past returns, my expectation regarding risk is that the markets will remain more volatile than in the past, and finally I 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.

Regarding the criticism that allocations are determined at the beginning of the investment process and never changed, except when they are rebalanced – a strategy I call “buy and forget” – again, unfortunately, many practitioners do follow this ostrich-like policy. But 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. Therefore, I review my assumptions at least annually, and my “strategic” allocations do in fact vary over time as a result of changes in my worldview. Rather than “buy and forget,” my policy is “buy and manage.”

Some may develop allocation models based solely on projections of historical data, but I do not. Some may also ignore valuations; again, I do not. And some may design allocation models and set them in stone; I do not.

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Harold Evensky is the president of Florida-based Evensky & Katz/Foldes, a fee-only financial planning firm, and an adjunct faculty member in the Texas Tech financial planning program. Harold is an internationally recognized author and speaker on investment management and financial planning topics, and has been the recipient of numerous industry awards.

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