The failure of asset allocation during the economic crisis to protect portfolios from harm has become a popular topic of late.  Tom Lauricella at the WSJ takes a look at how asset allocation as conducted broke down and how some practitioners of asset allocation are trying to salvage it as model for the future.

This begs the question:  is asset allocation done as a practice or does it just need to be modified to keep up with the times?  We delved into the topic of rising correlations and its role in asset allocation a couple of weeks ago.  A key takeaway from that discussion was that even if the economy and markets return to some new normal the memories of this period will remain with investors.

While the implementation of asset allocation is under attack, the actual mathematics behind the key concepts are not.  Every investor engages in asset allocation whether they know it or not.  In short, the math is the math, what is being called into question are the estimates used in constructing portfolios.

Looking back over the past few decades one can see how the practice of asset allocation could go wrong.  Economists have characterized the period since the early 1980s as the “Great Moderation” where we saw a significant reduction in economic volatility.  (Virginia Postrel in The Atlantic has a nice piece on the topic.) The business cycle had seemingly been tamed with higher economic growth and inflation well contained.

In this world one can see how practitioners might be caught up in the idea that any new asset class is a worthy one.  Indeed the term, asset class, was thrown around with some abandon.  In a benign environment “new” asset classes are pretty much guaranteed to look good in an asset allocation framework.  This might lead investors down the path of “naïve diversification.”  In an earlier piece we discussed how investors needed to approach each new claim of asset class status with a skeptical eye.

One could argue that this process sowed the seeds of its own demise.  As investors piled into any number of newish asset classes the very characteristics that made them attractive dissipated.   Once certain asset classes became commoditized and traded they inevitably become more correlated with the broader capital markets.

When the economy as a whole took a hit and investors pulled back on risky assets of any kind the flaws of this approach stood out.  Seemingly unrelated assets now traded in near lockstepDavid Merkel at the Aleph Blog notes that investors of all stripes were invested in far riskier portfolios that they thought.  This structural break from the Great Moderation leaves asset allocators with an uncertain future.

If the backward-looking historical approach was flawed, what are investors to do today?

We get some clues from the WSJ piece.  In it Lauricella reports that some advisers are now focusing on those asset classes that will perform better under periods of equity market stress including:  intermediate Treasury securities, TIPS and gold.  In addition to these “safe” assets one could also include higher cash holdings.

Justin Fox at the Curious Capitalist notes that this solution is not without its own risks.   Leaving aside the systematic risks of a global economic meltdown, this additional demand for seemingly safe assets may push down their returns to levels that make them unattractive.  Once again, the paradoxical effect of the actions of investors mitigating the very benefits they are seeking.

Asset allocation models can be characterized like any other model:  garbage in, garbage out.  That is not to say that practitioners were putting garbage into their asset allocation models.  An entire generation had been raised in a world free of significant economic downturns and where volatility was seemingly tamed.  It was simply the case that this backward looking approach was flawed.

The fact off the matter is that real diversification is difficult to achieve.  As stated, so-called safe assets have generally low real returns.  Over time the economic crisis will dissipate and standard asset classes will once again look attractive on a diversification basis.  However real diversification will require a more active approach on the part of investors.  Of course, active in the world of investing also means risky.   So to decrease risk, one needs to take on risk.  Nobody said this investing thing was easy.