The investment industry has made great strides in using technology to modernize the investment process. The growth of exchange-traded funds is testimony to the desire to increase liquidity and transparency, and lower transaction and management costs. Transaction fees are ever shrinking. Information technology puts market and investment information in managers' and investors' hands with lightning speed and laser accuracy.
But the most important part of the investment process — portfolio construction and management — is like using a rotary telephone! The asset allocation process is outdated, mired in 20th century thinking in a 21st century world, and — most importantly — fails to address investor needs.
Using risk allocation in place of asset allocation will change the way the investment industry thinks and operates proportionate to the way smartphones and networked devices have changed the way we communicate, gather and disseminate information. Risk knows the difference between T-bills and junk bonds, and sets the stage for all the enhancing apps that will not work in the rotary phone environment. We should protect our portfolios from significant risk of loss just the way we now protect ourselves from inclement weather, traffic jams and changes in tides — by using intelligently and coherently all the market information that is available at a moment's notice, rather than reading about the damage in the papers and on our account statements after the fact.
Risk allocation has several key advantages over asset allocation:
• Risk changes quickly, often daily — being unresponsive to it doesn't make sense. Traditional asset managers do not take the daily changes of risk into consideration. They instead focus on benchmark-relative performance, and wait until the end of each quarter to find out what happened to their portfolio and then rebalance. Would we wait 90 days to react to any other negative stimulus in our lives? Why allow asset managers to do so?
• Balanced allocations are no replacement for risk management. Traditional asset allocators use fixed allocations to bonds to control risk whereas risk managers use risk management to control risk.
Note the logic? Bonds don't control anything — they reduce returns too much when risk warrants more productive equity allocations, and do far too little to help when our portfolios really need it.
• Asset managers must rely on accurate forecasting, when evidence shows it cannot be done. According to Bloomberg, somewhere between 10% and 15% of economic and market forecasts come true. That means that seven out of eight times forecasts are wrong. That would be enough to get a student kicked out of school or an employee fired in any business except the investment industry. Perhaps John Kenneth Galbraith was right when he said: “The only function of economic forecasting is to make astrology look respectable.” Asset allocators stay up nights and weekends fretting over whether their allocation of assets to emerging markets should be 12.5% or 14%. The stress is palpable and unnecessary.
• Risk managers recognize that asset class relative returns are generally unpredictable, but risk and changes to risk are measurable – and if one has the wisdom to use it, significantly enhance returns over time. Rather than rely on impossible and unreliable forecasts, they rely instead on daily market observation and risk measurement. Risk managers play golf and tennis, and sail on weekends knowing that Monday might be treacherous, and they will be prepared to change market exposure on Tuesday if they need to get out of harm's way.