The Myth of Asset Allocation
or
Would you rather beat the market or make money?
John O. Low
Institutional Investor Counsel
American Asset Management Group, Inc.
50 West Montgomery Avenue Suite 110
Rockville, MD 20850
Phone 301-251-1002
[email protected]
© 2012 American Asset Management Group, Inc.
Archetypal Investment Philosophies
• Absolute Return vs. Relative return
• Risk
• Ascent of Relative Return
o 1952-MPT
o 1960s-EMH
o 1964-CAPM
• Secular Market Cycles
• The Investment Policy Statement and IPS
• Conclusion
Risk
• Systematic Risk a.k.a. undiversifiable risk or market risk
“The risk inherent in the entire market or an entire market segment.”*
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changes in interest rates
war
consumer prices
employment/unemployment factors
political/regulatory changes
• Non-Systematic Risk a.k.a. diversifiable risk or unsystematic risk
“Risk that is unique to a certain asset or company.” **
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labor strikes and other problems
natural disaster/weather problems
result of unfavorable litigation
Management
corporate fraud/malfeasance,
*.” [Financial Dictionary, <a href="http://financial-dictionary.thefreedictionary.com/Systematic+risk">Systematic
Risk</a>]
**[Financial Dictionary, <a href="http://financial-dictionary.thefreedictionary.com/unsystematic+risk">Unsystematic
Risk</a>]
Modern Portfolio Theory [MPT]
Harry Markowitz
• 1952/1959
• Volatility = Risk
• Mathematical model/proof showing that
diversification could reduce volatility (risk)
• Efficient Frontier
Underlying assumption: Correlation is the key-assets in a portfolio should NOT be chosen on their
own individual merits, but rather in consideration
of how their changes in price (volatility) relate to
the other assets in the portfolio.
Efficient Frontier
Efficient Market Hypothesis
• Eugene Fama – 1960s PhD. Thesis for University
of Chicago Booth School of Business.
Republished and refined in 1970
• Weak – prices already reflect all past publicly
available information
• Semi-Strong – prices reflect all publicly available
information AND instantly change to reflect new
information
• Strong – prices also instantly reflect all
private/insider information
Capital Asset Pricing Model [CAPM]
• Bill Sharpe (among others) – 1964
• Defines volatility (risk) as beta
• Mathematical model for individual asset
pricing (beta coefficient)
Dominant and Secondary Risks
RELATIVE RETURN (BENCHMARK)
INVESTING
ABSOLUTE RETURN INVESTING
MARKET
SECURITY
SECURITY
MARKET
Why?
• Wall Street Sales Machine
Training
Research/punditry
• Regulatory Environment
• Secular Bull Market
Easterling, Ed. Unexpected Returns. Fort Bragg: Cypress House, 2005. Print.
Time Frame
Duration
1901-1920
Number of
Recessions
Starting P/E
Finishing
P/E
Decline (Inf.
Adjusted)
19 Yrs 6 Mos 6
25.2
5.1
-69%
1929-1949
19 Yrs 9 Mos 4
32.6
9.1
-67%
1966-1982
16 Yrs 6 Mos 4
24.1
6.6
-62%
AVERAGE
18 Yrs 7 Mos 4.7
27.3
6.9
-66%
2000Present
(as of July 9,
2012)
11 Yrs 5 Mos 2
44.2
22.4
-37%
Pring Turner Capital Group www.pringturner.com
Relative Return Manager 2002-2003
Absolute Return Manager 2002-2003
Relative vs. Absolute
Easterling, Ed. Unexpected Returns. Pps. 197-198
The Investment Policy Statement
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Any organization that has assets to invest should also have appropriate policies to
guide these investments. One set of policies does not fit every organization but
each organization needs to define its own goals and understand its own fiduciary
responsibilities. Here is a list of the basic points to cover. Any investment policies
should
be developed with the advice of a financial professional or be reviewed by legal
counsel
define general objectives (preserve and protect the assets; achieve aggressive
growth)
delegate day-to-day asset management to an independent finance committee or a
professional manager
set asset allocation parameters (include diversification)
describe asset quality (itemize quality ratings for stocks, bonds, or short-term
reserves based on your risk tolerance)
define the investment manager's accountability (include risk in transactions, social
responsibility, reporting requirements, and coverage of cash flow needs)
establish a system for regular review of the policies
Thomas A. McLaughlin, Financial Committees (BoardSource 2004).
Robert P. Frye, Jr., Minding the Money: An Investment Guide for Nonprofit Board Members (BoardSource 2004).
Sample Asset Allocation Models
EXAMPLE 1:
UCRP [$3.2b]
EXAMPLE 2:
501(c)3 reserve acct. [$2.6mm]
The Investment Policy Statement
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Primacy
Self-authored
Vision
Clarity
Flexibility
Revisited
John O. Low
Institutional Investor Counsel
American Asset Management Group, Inc.
50 West Montgomery Avenue Suite 110
Rockville, MD 20850
Phone 301-251-1002
[email protected]
This presentation is copyrighted 2012 by American Asset Management Group, Inc. and is its property. No
unauthorized duplication or rebroadcast is allowed.
The owner gratefully acknowledges Ed Easterling, and Crestmont Research for their help.