ITA Wealth Management

To prove I do not “cherry pick” my sources and glean only the fruit that supports my positions, I am writing about another sacred investment issue, that of asset allocation.  Michael Edesess has a sub-section in Chapter 14 and titles it ‘The Asset Allocation Scam.’  Edesess tackles the 1986 Brinson, Hood & Beebower (BHB) paper and he is certainly not the first to do so.  He writes about the BHB paper as follows.  “The result was merely that most of the fluctuation (i.e., the variability or volatility) in investment returns was due to “strategic asset allocation” or “investment policy” –that is, chiefly to the way the portfolio was divided between stocks and bonds.”

“In view of the theories and virtually all the empirical evidence to date, the BHB results was not in the least novel or surprising.  The division between stocks and bonds pretty much determines the risk being taken in the portfolio.  So, of course, it will have a major influence on how much the portfolio’s returns fluctuate.”

“But the investment profession immediately transformed this simple and unremarkable result into a new approach to investment advice and management, an approach that used an exhibit that seems to have a mesmerizing effect on people — the pie chart.”

“It was all the consequence of slight word changes in the findings of the BHB article. The study says nothing more than that the average stock-bond allocation over time matters more to a portfolio’s volatility, its riskiness, than anything else–something of a plain-horse-and-wagon finding.”

This is where the knife is plunged deeper and twisted 180 degrees.

“But this result was transformed by the Marcos of the business into a much more elaborate asset allocation decision.  Now the advisor tells you that you must allocate not only between stocks and bonds but among a larger number of “style’ categories.  Of course, the advisor can tell you how to do that right.  The universe of stocks is taken apart into “styles,” such as large growth, large value, small growth, small value, and the like, and percentage allocations to them are recommended using …a nicely colored pie chart!”

“The end result of the allocation is that you’ll get essentially the same well-diversified mix of stocks as an index fund.  But an index fund is too simple and might make you wonder why you need the advisor.  Besides, when an advisor recommends an index fund, he gets no kickback from the fund (unless it’s a phony higher-cost “index” fund with worthless bells and whistles added).  But if each of your style categories needs a separate fund that specializes in that unique style, well, that’s starting to look a little more complicated and interesting.”

When I finished a careful reading of this section of Edesess’ book, I immediately went to the index to find a reference to Fama & French.  My assumption was that I would find a reference to their impressive work published in the June 1992 issue of the Journal of Finance. Nothing!  Not a mention of their paper.  Hmm.  Why not?  We will need to take this up later.  In the interim, readers can search this blog for references to Fama and French to see why their paper is so important when it comes to developing a portfolio plan.

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Lowell Herr

Photograph:  Near Sunriver, Oregon

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