Wednesday, June 22, 2011

Seeking Perfect Asset Allocation Has Its Dangers

A recent Canadian Capitalist article on Burton Malkiel's Contradictory Advice generated comments discussing what constitutes proper asset allocation for passive investors. I think these worries can lead investors to make bigger mistakes than just having an imperfect asset allocation.

Malkiel advocates an increased allocation to Chinese equities. Some argue that this makes sense because the Chinese stock market is small relative to its GDP. Others observe that Malkiel's advice is self-serving because he is associated with Chinese ETFs. I think the debate about the perfect asset allocation is less important than the benefit of sticking to a plan.

It is true that improving your asset allocation to the best percentages of various assets classes (bonds/stocks, domestic/foreign, large-cap/small-cap, etc.) may give a small boost to returns for a given level of risk. However, any reasonable allocation that matches your risk tolerance is likely to be close enough. The real concern is whether you frequently jump to the latest and greatest allocation.

What might look like clever shifts to ever more sophisticated asset allocations may be just a case of chasing the latest hot trend. If you were persuaded by the arguments to buy more Chinese equities, are you seeking exposure proportional to the Chinese GDP or is the real reason that China seems hot right now?

As Canadian Capitalist says, could you be persuaded to add First Trust NASDAQ CEA Smartphone ETF (FONE) because "Smartphones are pretty hot these days"? The world is full of temptations to deviate from passive investing. Even the prospect of better passive investing can be just performance chasing in disguise if you make frequent changes.


  1. @CC: I guess that makes sense sometimes. If we think of Madoff as an asset class, then it makes sense to stay away now that he is very "cheap". But many other asset classes are best bought when recent performance has been bad. Rebalance, rebalance, rebalance.

    1. The comment above is a reply to Canadian Capitalist's comment:

      Thanks for the mention Michael. Funnily enough, there are not many advocates of (and investors in) a new asset class whose recent performance stinks.

  2. Thank for making this point so clearly. There seems to be this idea that a major part of index investing is the search for the perfect asset mix, or the design of the perfect index. The fact is, these are just details. They're worth discussing (in a geeky sort of way) but they're not the difference between success and failure in investing.

    There's no perfect asset allocation. Adding a bit more China (or no China at all) in a portfolio is not likely to make a big difference one way or the other. Choose a reasonable mix of asset classes with low correlation, rebalance occasionally and stick to the plan. Simple, though not easy.

  3. @Canadian Couch Potato: The urge to tinker is powerful in most people. Unfortunately, tinkering will likely lose money.

  4. Very intellectual points here. I got nothing against asset allocation in general but I do think we need to be reminded that MPT is bacwards looking. While the past sometimes mirors the future, its never exactly the same and the next decade for ceratin asset classes like bonds have now become predictable. I do believe a forward looking approach to portfolio construction is required as well. Thanks again for the compelling points. I learn everyday.

    Alpha Money Advisor