Consider the outcomes delivered by a diversified group of asset classes in the period from 2000 to 2002 and compare those with the dramatically different outcomes in 2008. Last year, stocks, corporate bonds, REITs and commodities suffered steep losses. Only government bonds bucked the trend with positive returns. But the previous bear market was a different animal entirely. Although stocks took a beating from 2000 to 2002, bonds, commodities and REITs posted handsome gains. Why the difference? Valuation was one reason, and arguably the dominant reason.
Consider that the U.S. stock market peaked in March 2000. At that point, yields on REITs traded at an enticing 8.3%, or well above the 6.3% for the benchmark 10-year Treasury note at the time. By contrast, U.S. stocks at the time posted a paltry trailing yield of less than 1.2%, based on monthly data for the S&P Composite-an all-time low. Over the course of the next three years, REITs rose nearly 44%, while U.S. stocks retreated by 40%.
There was no repeat performance last year, of course, when REITs tumbled 39%, exceeding even the steep 37% loss for U.S. stocks. Why the difference? Valuation once again appears to offer a clue. At the last peak for stocks in October 2007, the REIT yield was 4.2%-slightly below the 10-year Treasury's 4.5%. Was there a compelling case to buy REITs when a risk-free Treasury note offered a higher yield? Apparently not. REITs looked compelling in early 2000, but they seemed overpriced in late 2007. Then again, saying as much at the time was tantamount to being labeled a market timer.
Labels aside, ignoring the price of risk isn't a strategy; it's denial. Even worse, it courts trouble when you're managing asset allocation. It's easy to say that market timing is a loser's game, but the truth is that it's naïve to compare market timing with adjusting asset allocation based on the expected price of risk.
"What is crucial to the success of diversification is the price you pay for initiating exposure to different asset classes," says Adrian Cronje, director of asset allocation at Wilmington Trust. "At certain times, you're paid to assume risk; at other times you're not paid to assume risk."
The price of risk changes, so asset allocation should respond to some degree to these changes, says Gary Brinson, a veteran strategist who co-authored a famous 1986 research paper that brought asset allocation to the fore as an investment concept. "You need to change asset allocation over time," advises Brinson, who is also president of GP Brinson, an investment firm in Chicago.
That's especially true in periods of extremes, when expected risk premiums are abnormally high or low. In those times, the future may be less uncertain than usual.
It's difficult for anybody to estimate a return, of course, and no one can be confident that the future is clear. A dose of humility is always required when you're making investment assumptions, especially these days when volatility and uncertainty are much amplified. But you would also be wrong to say that you somehow won't ever be bogged down by the messy work of prediction.
To be sure, there's value in considering the long-run return as one of many elements for crafting asset allocation. But by relying on it exclusively you needlessly increase risk, since this approach to diversifying among asset classes makes a tacit assumption that returns are stable.
The fact that expected returns vary through time warrants a dynamic asset allocation, or at least a partly dynamic portfolio strategy. There's a danger here, of course, in that predicting returns is prone to error. But so, too, is expecting stable returns to hold in any given year, or even over five or ten years. Perhaps doing some of both is a reasonable compromise. But that raises the question: How should financial advisors build return estimates?