Theory and practice don’t always converge in finance, but when they do it’s usually because the evidence that a theory works in practice is persuasive, if not blindingly obvious. Perhaps the best example is the universally accepted wisdom that investment portfolios should be—must be—customized for different investors to reflect the differences in their objectives, risk tolerance, time horizon and so on. Embraced in practice and emphasized in theory, this guiding principle for portfolio design is virtually unchallenged. But that’s where the agreement ends—and the controversy and questions begin.
The key difference between finance theory and the way advisors actually build portfolios is the preference for variety in asset allocation. The academic solution shuns it, whereas most advisors prefer some degree of it.
In textbook customization, there’s only one “optimal” mix of risky assets, and it should be used as the foundation for every investor. Defining “optimal” is a separate debate. Classic finance theory tells us the ideal is a market-weighted allocation to all the major asset classes. Regardless of how you define “optimal,” ask yourself a question: Once you’ve identified what you believe to be an unrivaled strategy for maximizing risk-adjusted return, should you offer it as is to all your clients?
Theory answers “yes.” The only nod to customization is adjusting the weight of the “optimal” risk portfolio relative to a cash (or equivalent) allocation. For example, an 80-year-old widow might hold a portfolio of 90% cash with only 10% in the optimal mix of risky assets. By contrast, a 25-year-old might flip that mix on its head by allocating 90% to the same risky portfolio and just 10% to cash. The reason for the allocation difference, of course, is that greater exposure to risk is suitable for investors who are willing and able to tolerate it in the quest to earn a higher return.
Most advisors agree, but they offer different asset allocations to clients anyway—a preference that Peter Bernstein labeled the “interior decorator fallacy” in Capital Ideas, in which they believe they must add value by tailoring each portfolio. Fallacy? Yes, Bernstein advised, because choosing assets within each asset class should be separate from deciding how to weight the overall set of risky assets relative to safe assets. Conflating the two threatens to undermine the best-laid plans for earning a satisfactory risk premium overall.
Investment professionals don’t follow the standard advice on asset allocation—the so-called mutual-fund separation theorem formally outlined by Nobel prize-winning economist James Tobin more than a half-century ago. In practice, advisors dispatch “more complicated strategies than indicated by the theorem,” noted Niko Canner, Gregory Mankiw and David Weil in their 1997 essay, “An Asset Allocation Puzzle,” which appeared in The American Economic Review. “This advice,” they wrote, “contradicts the conclusion that all investors should hold risky assets in the same proportion.”
Sixteen years later, advisors still have a preference for recommending and building portfolios that are more complicated than theory proposes. Why? The authors of the 1997 paper considered several explanations, including the lack of a genuinely “riskless” asset; complications that arise from favoring the advantages of dynamic asset allocation; and the assumption that investors care about factors beyond the mean and variance of portfolio returns, which are the building blocks for the fund separation theorem. Nonetheless, the “Puzzle” authors report that none of the obvious explanations offer a convincing answer for why advisors favor multiple risky portfolio allocations rather than just one.
Do advisors in the 21st century have more convincing explanations for channeling their interior decorator muses when it comes to building investment portfolios?
A Radical Idea
The puzzle, if we can call it that, would be solved if building multiple asset allocation strategies for each client routinely led to higher returns, lower risk or both. But that’s not the case, at least not as a general rule. Portfolios that hug passive or quasi-passive asset allocation mixes and that are rebalanced every year or two have a habit of delivering average or above-average results against a large pool of actively designed and managed counterparts. The active strategies always produce winners, of course, but they’re routinely offset, and then some, by the relatively weak hands.
The pursuit of above-average returns, misguided or not, surely motivates a fair share of the interior investment decorating. But there are “many legitimate reasons why different portfolios of risky assets might be appropriate for different investors,” write the authors of Strategic Asset Allocation: Portfolio Choice for Long-Term Investors. Written by three financial economists, this academic but accessible 2002 book squarely favors portfolios of different asset allocations for different investors. “The key is to recognize that optimal portfolios for long-term investors need not be the same as for short-term investors.”
Though most financial advisors agree, Brian Royal, the founder of NorthStar Capital in Rustburg, Va., embraces what some might call a radical idea: one risk allocation for all clients. “For the assets that are at risk, they’re managed the same,” Royal says.
All of Royal’s clients, more than 150 of them, have the same risk allocation, he explains. But the portfolios are then customized with varying allocations to a “riskless” asset, which he defines as short-term, low-cost annuities. Although this is textbook asset allocation, no one will confuse his strategy as passive. For the risky component of his portfolios, he practices his own tactical asset allocation, primarily with ETFs.
Whatever the investment benefits tied to a one-risk-portfolio-for-all strategy, there are several operational advantages, too. For obvious reasons, managing what amounts to a single portfolio for everyone is considerably easier and more efficient than running a wide array of strategies. It seems you’re more likely to find success by harnessing all your resources in building one killer portfolio than in trying to excel across multiple fronts.
There’s also an issue of fairness, Royal says. If an advisor has designed what he thinks is the strongest portfolio for generating a risk premium through time, how can he rationalize giving some clients what might be described as the second-best strategy? It might be possible to design several winning portfolios. But some folks have trouble coming up with just one robust strategy, to say nothing of five or six. Even if you can beat the odds, there’s still the extra challenge of monitoring a wide array of strategies, year after year.
Gray Areas
One rationale I often hear from advisors for building distinct allocations is that real-world investing is never as clean-cut as it is on the pages of economics textbooks. Practical modifications to theory are therefore essential, if not inevitable. “There are trade-offs with customization versus efficiency,” says Paul Jacobs, chief investment officer of Palisades Hudson Financial Group. “If you look at each account that we manage, there is customization with many of our portfolios. I may have a client with a position in employer stock, and so I may try to hedge that with investments that I think balance out the risks. There may be tax issues too.”
Nonetheless, Jacobs says there are two basic decisions for designing an asset allocation for clients. The first is deciding how much to allocate to stocks, fixed income, cash and alternative asset classes. The second is choosing how to divvy up the mix within each of those broad areas—equity weights for the U.S., Europe and Asia, for instance.
That leaves plenty of room for variety, although Jacobs and his team put a limit on specialization. “We do gain efficiency by having typical allocations to stocks, for instance.” That’s no trivial matter for a shop that manages more than $1 billion for 60 families. No wonder that Palisades Hudson, like many firms, tends to gravitate to a middle ground, somewhere between the extremes of theory and practice. For some advisors, this is as much about managing the quality of the brand and delivering a relatively consistent service as it is about pursuing above-average results and keeping customization from spinning out of control.
Most of the portfolio strategies at Financial Advantage Inc. in Columbia, Md., fall into one of three predefined “investment profiles,” says chief investment officer Mike Martin. This is partly a recognition that there’s a practical limit on the variety of investment objectives. The firm also wants to keep its advisors from going off on a strategic tangent. “It’s important that when a client comes to us, they [recognize that] they’re hiring a company, not an advisor,” Martin explains.
Theory may advocate one strategy for all, but the financial industry’s evolution promotes going in the other direction. “The world is headed toward more and more personalization,” says Phil DeMuth of Conservative Wealth Management, a co-author of several books with Ben Stein, including The Little Book of Bulletproof Investing. Technology and the explosion of digital data, DeMuth reminds us, are making it increasingly easy to build and maintain unique portfolios. “That’s where we’re going as a profession—a place where advisors can add value.”
The proliferation of ETFs in recent years, which slice and dice the world’s markets into an ever-finer menu of betas, is a key part of the push toward customization. Since the opportunities have been expanded and democratized, advisors feel more of an attraction to building better mousetraps. State-of-the-art asset allocation was once defined by fairly simple rules of thumb—the classic 60%/40% domestic stock/bond portfolio, for instance. Simplicity was often a necessity in an era when the variety of investment products was relatively limited. Today, the combination of low-cost ETFs that target a wide spectrum of asset classes and software packages that can analyze and manage complex strategies has eliminated barriers and redefined “practical” investing principles.
The financial industry never tires of pushing the mantra that more is better—more trading, more products, more nuance. Performance doesn’t seem to keep pace. But at the same time, mediocrity has been around a long time, and it has little to do with product choices per se.
A Fine Balance
Does all this mean there’s an either/or choice? Must you embrace theory entirely, or throw it out and practice your own brand of customization? Not so fast, says Adrian Cronje, chief investment officer at Balentine LLC, a fee-only RIA in Atlanta. “Truth lies somewhere between the two extremes,” he says.
Figure 1
Balentine’s interpretation of asset allocation “truth” starts with five basic building blocks. “Instead of thinking of 30 different asset classes to build portfolios, we group asset classes by risks that matter,” says Cronje. Each client holds a different portfolio mix of five different risk categories defined by Cronje and his team (see Figure 1).
For example, an investor with a low risk tolerance may be overweight in the safe assets block, while a more aggressive client may hold more of the global market risk block.
Why not do the same with the standard definitions of asset classes? The short answer, according to Cronje, is that risk is more than just price volatility, which is the textbook definition.
Theory isn’t worthless, he admits, and it’s a mistake to dismiss it entirely. But it needs some modification in the real world. A risk-averse client, for example, may not need liquidity, while a so-called risk-tolerant investor may still require a fair amount of it. Standard finance theory doesn’t offer great solutions for these special cases.
Cronje’s an economist with a Ph.D. from Cambridge who previously headed the investment strategy team at Wilmington Trust. Having developed a keen appreciation for both theorists and practitioners, he opines that “good theory gives good insight into the world, based on good assumptions.” He allows that modern portfolio theory is a reasonable starting point. But it’s incomplete for application, as is, in the real world.
“In theory, theory and practice are the same,” Albert Einstein reportedly said. “In practice, they are not.” This quip by the 20th century’s greatest physicist may be apocryphal, but the wisdom behind the quote—for finance and beyond—is self-evident.