Choosing simplicity in the new year

The beginning of the new year is filled with all manner of content on resolutions, keeping your resolutions, etc. This year it seems there is a budding meme on the importance of simplicity in investing. For example a recent post at Investment News looks at some research by Vanguard on the value of the simple 60/40 balanced portfolio. They show that many asset classes claimed to be diversifiers do not hold up to scrutiny. In short a simple asset allocation avoids the complexity and risk of a more daring portfolio, Jason Kephart writes:

“The risks of trying to avoid the risks [of the 60/40 portfolio] are greater than the risks themselves,” Mr. Kinniry said.

The reason he is confident in the classic strategy is that over the past 20 years, nothing has been a better hedge against the downside in equities than investment-grade bonds.

Roger Nusbaum at Random Roger notes how the big push in to commodities has fizzled out as well as investors give up on the presumed easy diversification benefits. Roger writes:

I don’t know if anyone is still preaches putting 20% in REITs and commodities respectively but long time readers may recall I have been saying that was a bad idea before the crisis and I still believe that now; 20% is way too much.

To a certain degree individuals are simply taking the lead of institutions. Prior to the financial crisis the endowment model was one commonly aped by institutions. That push by institutions into alternative asset classes seems to still be at work. However there is a big problem. Julie Segal at Institutional Investor highlights some findings from the State Street’s Center for Applied Research:

“Irrespective of their stated goal, institutional investors are exhibiting a herd mentality by increasing their exposure to alternatives,” says Suzanne Duncan, the report’s Boston-based author. “While there is nothing wrong with alternatives, what’s worrisome is that investors feel unprepared to handle the risks and complexity.”

Embracing simplicity is something I have been writing about about in the blog an in the book. One of the overlooked reasons to embrace simplicity is that it helps you avoid the principal-agent problem in investing. If your investments are ones that don’t require active management or involve potential incentive issues you can bypass some of these potential pitfalls. In short, an index fund does not worry about its own performance at year-end.

Year-end is also a typical time that investors look to rebalance their portfolios. Barry Ritholtz at the Big Picture asks (and answers) why investors should have a plan in place to rebalance their portfolios. He writes:

Why do this? Because history teaches us that all broad asset classes will eventually mean revert. The goal of the rebalance is to take advantage of the short term volatility and price swings to move you back towards your model 60/40 allocations at more advantageous valuations.

A quick glance at recent asset class performance reinforces why both diversification and a systematic approach are important. It is easy to get caught up in the movement of the next, new great asset class. The flip side is also true. It is easy to get caught up in despair when markets tank. Roben Farzad at Businessweek looks at how a boring portfolio would have performance before, during and after the financial crisis. The results are not too bad. Unfortunately for many they were unable to hang on and gave up on the stock market altogether. Farzard writes:

In reality, those who stayed sober, diversified, and total-return minded (and bothered to remember their brokerage log-ins) should be feeling ecstatic. Indeed, many had reason to celebrate three years ago. Thing is, ecstasy—like panic—does not often visit this cohort.

It is easy to forget that one of the byproducts of active strategies and frequent portfolio changes is high costs. As I note in my book it perfectly acceptable to accept investment mediocrity provided you don’t pay a high price in terms of time or money to get there. James Picerno at the Capital Spectator echoes this sentiment:

The lesson for most folks is that broad diversification across asset classes, and periodic rebalancing of those assets, will capture average to above-average returns on a fairly reliable basis through time. The flip side of this lesson is that trying too hard in money management boosts the odds of ending up with high-priced mediocrity, or worse.

It is easy to extol the virtues of a simple investment strategy after a good year for the stock markets. One thing I can guarantee is that at some point this year there will be a time when a simple strategy will look stupid. Either the stock market will have taken off and anything non-equity related will look like a dead weight on a portfolio. Or the stock market will correct and any kind of equity exposure will seem like too much. That is unfortunately the nature of the beast. Sticking with your strategy, as imperfect as it is, will seem like a herculean task, not unlike all those other resolutions we undertake at the beginning of the year. Then again, what is the alternative?

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