Two years ago, Bruce Smith and his wife, Sheila, hired a financial adviser for the first time. The couple dutifully followed the advice and spread their cash among a handful of mutual funds of various types: U.S. blue chips, small stocks, some with a “value” approach, some with a “growth” approach, a little international, and, yes, some bond exposure too.
Then, as their Toyota Camry portfolio was dusted by the Porsches of the roaring tech-stock world, the concept of diversifying their investments to cut their risk suddenly seemed pretty lame.
“I get a little cranky with him,” says Smith. “He says you should be happy with 18 percent returns. I say I’m happier with 44 percent.”
“Him” is Mark Cortazzo, a fee-based financial adviser in Parsippany, N.J. “Within four or five months, I said I wanted to take some of my money and invest it myself,” recalls Smith, 46 years old, a vice president at Infonet, an international telecom company that went public in December. “It’s gotten to the point where, everything he put me in, I’m out of.”
So much for asset allocation. Just a few years ago, investors and financial advisers embraced the idea that you could reduce your risk and, in some cases, actually boost your returns by spreading your investments among assets that didn’t all move in the same direction at the same time.
Yet the domination of the market in recent years by big domestic growth stocks, particularly tech shares of late, has left advocates of this strategy struggling to explain why their portfolios have performed so poorly. But individual investors are not waiting for an explanation. Instead, they are pouring money into the best-performing assets rather than rebalancing their portfolios as asset allocation demands, by shifting money into the most beaten-up part of the market.
“I think expectations are becoming more and more difficult to meet with clients,” says Cortazzo.
The concept of asset allocation dates back to the work of Nobel laureates Harry Markowitz in the early 1950s and William Sharpe a decade or so later, who together showed how risk and return were related and how investors could better control both.
But the academic work didn’t reach individual investors until the late ’80s, early ’90s when companies such as Ibbotson Associates produced software that allowed individuals, or their financial advisers, to use asset allocation to produce their very own portfolios.
Financial advisers fell in love with these products. Particularly smitten were the new, fast-growing breed of fee-only planners who promised investors more comprehensive advice than they would get from brokers motivated by commissions.
The advisers would quiz their clients about their financial wants and needs, risk tolerance and personal goals, and the software would spit out a multicolored pie chart suitable for presentation to the duly-impressed client.
The mid ’90s were the heyday of asset allocation. To meet demand, fund companies launched thousands of funds to fill every possible allocation niche.
And the markets cooperated wonderfully. In the U.S., small caps dominated in 1991 and 1992; overseas, emerging markets went on a tear in 1993 and 1994. If not for asset allocation, most investors, who generally had the bulk of their portfolios in big blue-chip stocks, would have missed these great rallies.
Then the markets turned against this strategy. First, some of the niche investments such as emerging markets and real estate stumbled, then the U.S. market narrowed as the domestic blue-chip stocks that make up the Standard & Poor’s 500 stock index began a four-year streak in which they left nearly every other asset class far behind.
And the stocks that were leading the market were precisely the ones that advisers were telling their clients to sell, in order to reallocate to maintain that perfectly allocated portfolio.
The one-two knockout combination came in the summer of 1998, when nearly every sector of the market was pummeled, leaving even the most carefully constructed portfolios flat on the floor. So much for the risk reduction that was supposed to come from asset classes not all moving in sync. Then big caps and tech stocks soared, giving the asset allocators performance envy as their friends’ supposedly inferior portfolios put up triple-digit numbers.
Now, financial advisers are struggling to keep clients, who more and more want to do it on their own. Fund companies are suffering too.
Ibbotson has begun selling a presentation for advisers to show their clients, “Do You Need Asset Allocation in a Bull Market?” Needless to say, the answer is yes. Larry Waschka, an adviser in Little Rock, Ark., has begun a series of dinners to educate his clients about the market’s risks. And every adviser has a story of a client who is fed up with the strategy.
“Million-dollar client calls up,” says Waschka, relating a typical tale of woe. “He’s been with us for seven years, and he says, `My son’s account was up 57 percent this year and you were only up 20 percent.’ I’m scratching my head. His son is a crazy, lunatic physician. The father is retired, who, when I first met him, only wanted to invest in bonds. I had to talk him into a balanced portfolio, much less tech stocks. I got him on the phone and said, `What is your son’s portfolio made up of?’ `Mostly tech stuff,’ he said. Then I said, `Do you realize you’re comparing M&Ms to a balanced meal? You like M&Ms, but you want the satisfaction of a balanced meal.’ “
Even supposedly sophisticated institutional investors are getting impatient. Gary Brinson is chairman of Chicago’s Brinson Partners, an institutional money-management firm that oversees $280 billion for both his clients and clients of UBS, which owns his firm. He’s also a co-author of a seminal article on asset allocation that argues that the bulk of an investor’s returns comes from the asset classes they invest in, rather than the individual securities. Even he is hearing complaints from clients.
His response? “You’re telling me your appetite for risk has genuinely changed, and you can say, without a smirk on your face, that if we get into a dark period that you’re not going to abandon the risk appetite that you are so forcefully claiming is a new revelation?” Brinson says. “Most of them listen very carefully. They know if they change now, and then change back, they are doing the worst thing in the world in investing.” He adds, “And they have to face me.”
Financial advisers say their greatest error in promoting asset allocation was that they didn’t educate their clients enough, especially to the fact that asset allocation tends to do more to reduce risk than it does to boost returns. In fact, investors’ appetite for the riskiest, highest-flying parts of the market demonstrates they are more interested in top-notch performance than risk reduction.
