Quarter in Review

In my professional reading there have been a number of investors/authors who are expressing opinions that asset allocation as we know it is dead. Doesn’t work anymore. Kaput. Most such articles are aimed at people who invest for a living. In case you have seen such an article or heard it on radio, TV or the internet, allow me to give you my “take” on the situation.

First of all, we have to identify what kind of asset allocation they are talking about. Here at HSC each client has a strategic asset allocation, which is the mix of bonds funds vs. stock funds the planners believe will accomplish the client’s long term goals. A typical strategic allocation might be 60% stock funds and 40% bond funds. It will change only when the client’s goals change. But there are many types of stock and bond funds. The allocations within the broad categories of stock and bond funds are the client’s “tactical” allocation. This allocation will shift as macro-economic conditions change.

The strategic level of asset allocation continues to work very well. We try to have sufficient holdings in bond funds to be able to provide cash to live on during a multiyear stock downturn. When the client needs cash, we will sell stock funds, unless the stock market is down. Then we will sell bond funds, which tend to be up, or at least retain their value, when stocks are down. In other words, the strategic asset allocation allows us to buy low and sell high. Very desirable.

This opposite behavior between stock and bonds actually makes sense. The major threat to bonds is rising interest rates. Interest rates tend to rise when there is inflation or threat thereof. We tend to have inflation when employment, wages, and production are up, conditions that favor a booming stock market. Thus what is good news for the stock market is bad news for the bond market and vice versa.

So what are these “asset allocation is dead” folks talking about? Mostly, they are talking about the “tactical” allocation of stock funds. In the past, international stocks behaved quite differently from U.S. stocks. More recently, the world economy has integrated. International stocks now have much the same growth patterns as U.S. stocks.

Let’s cite an example to help clarify. In the example cited in the second paragraph of a strategic allocation of 60% stock funds and 40% bond funds, suppose the tactical allocation of the bond funds was half long term bonds and half mid-term bonds. If inflation started rearing its ugly head, the investment advisors might replace the long term bond funds with short term and inflation protected bond funds. Within the stock sector they might consider moving a portion of the U.S. growth stock funds to natural resource and real estate funds that do especially well under inflationary conditions. So the strategic allocation remains 60/40 stocks to bonds, but things could change a bit within the stock and bond sectors, depending upon the macro-economic conditions. In actuality, there are two levels of tactical asset allocation.

The HSC investment advisors can modify the amounts of various types of mutual funds, within the strategic allocation as depicted above. But there is actually a second level of tactical asset allocation. Because we use mostly actively managed funds, the individual fund managers may also change their tactical allocations within the constraints of their fund’s prospectus. (Some fund managers have more “wiggle room” than others.)

Bottom line, HSC clients’ portfolios are dynamic, with a lot of tactical changes occurring that may not be evident in the day-to-day portfolio management, all within the context of a relatively stable strategic allocation. So, is asset allocation dead? It is not as dynamic as it used to be among stock funds. It can be important in the bond sector. And it is still vital at the strategic level. Buying low and selling high remains the objective of every investor on the planet!