The problem with asset allocation

What is asset allocation and why discuss it? Surely super is all about putting money away for retirement: how hard can that be?

In this post, I will outline the conventional thinking regarding asset allocation and why it’s mostly wrong. The empirical evidence regarding this contention is overwhelming and stark. The major academic theories that bind financial planners and the investment industry to this convention have been thoroughly disproved in the real world. They are no more applicable than stating the earth is flat, or that it was made in seven days, even if their originators were awarded Nobel Prizes (or blew up billions of dollars in the process)

In a second post, I will outline my proposed solutions, how an investor may steer themselves through the flotsam and jetsam of flawed conventional thinking on asset allocation, and come out the other side with a clarity on how to apply these solutions to a real world.

What is Asset Allocation?
Asset allocation encompasses three areas:

  • Where to put your capital (i.e to get return on your capital)
  • When to put the capital in and when to take it out (i.e timing)
  • How to manage risk (i.e the return of your capital)

Conventional thinking calls these three areas “Strategic Asset Allocation”, “Tactical Asset Allocation” and “Risk Management”. They are all based on the misnamed “Modern Portfolio Theory” and “Efficient Market Hypothesis”. A background to these theorems, assumptions and concepts is vital in understanding conventional asset allocation.

Modern Portfolio Theory (MPT)
What is MPT? From Wikipedia:

The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected individually, each on their own merits. Rather, it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price.
Investing is a tradeoff between risk and expected return. In general, assets with higher expected returns are riskier. For a given amount of risk, MPT describes how to select a portfolio with the highest possible expected return. Or, for a given expected return, MPT explains how to select a portfolio with the lowest possible risk.

A portfolio can therefore be mathematically created and allocated for every type of investor, providing the best expected outcome (adjusted for their tolerance to risk) using the above concepts. The math is interesting, if a little simple (e.g using a normal distribution of returns on assets to calculate risk by standard deviation has been completely debunked), but I won’t repeat it here, suffice to say it feeds into the neoclassical economist tradition of using simple mathematics to try to explain a complex phenomenon that has more to do with irrational human behaviour than numbers.

The result is called the “efficient frontier” (where no economist has gone before?):

Which you’ve probably seen in a glossy brochure or lightweight look at asset allocation on your super funds website in this form:

The Efficient Market Hypothesis – EMH
EMH is the mathematical determination that all financial markets (e.g stocks, bonds, property) are informationally efficient, that is no-one can achieve returns higher than the their respective market, because prices already discount or have already determined the equilibrium value of the underlying asset. That is, price equals value and markets will always (or at least most of the time) reflect this.

The EMH ties into MPT nicely, as it underpins the assumptions used to create the “perfect portfolio” and it further entrenches the dogma that you can divine a specific return from secondary asset markets whilst managing risk.

The Price is wrong, b%tch
Suffice to say, the Great Recession (called the GFC in Australia) finally sounded the death knell of this flawed concept, although it lives on in the minds of failed economists and central bankers. Beyond the practical and empirical refutation, the dogmatic concept that markets are “king” and are the most efficient way of allocating capital (since the market price must equal its value) led to the abandoning of sound regulation and oversight of financial markets, particularly shares and property. One of the worst offshoots was the securitisation and further creation of derivatives (e.g CDO’s, RMBS) using the EMH as a mathematical basis of their “soundness”.

The empirical evidence is stark, particularly after the GFC when commentators, economists and other participants went on an introspective crusade to find out how it all happened. Jeremy Grantham, of GMO has summed it up here:

“In their desire for mathematical order and elegant models, the economic establishment played down the role of bad behavior” — not to mention “flat-out bursts of irrationality.
The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. ‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.”

Taking apart the flaws
MPT and EMH, and therefore the basis of how your capital is allocated, rest upon the following flawed concepts:

  • Investors are rational and risk averse, which follows that you will only take on increased risk if you get higher returns.
  • Risk can be mathematically measured and an expected return calculated for individual investor’s
  • Asset risk is determined by their change in price, or volatility.
  • Different risk/return profiles can be created, depending on the investor’s tolerance of risk (e.g high growth, conservative and “balanced”)
  • Portfolio risk can be reduced by diversification, the process of holding different assets which are not correlated with each other. Therefore, you can have a higher expected return with lower risk.

Rationality is for Vulcans
First of all, investors are neither rational or risk averse. Behavioural economics shows that participants react differently and use different processes, sometimes wildly irrational, in determining investment decisions. This is the reason behind the creation and explosion of bubbles, not supply and demand curves. There are no pointy eared Vulcans at property auctions (maybe real estate agents dressed as Klingons?) or in front of computer screens at the ASX.

This is the first nail in the coffin of “price=value”. On the one hand, emotion drives the market price through fear and greed. On the other hand, we all value things differently – so there is no such thing as “intrinsic value” – the value cannot be calculated as we each have different perceptions of value.

Volatility is not Risk. Risk cannot be measured.
This leads to the very concept of risk. Risk cannot be calculated mathematically using volatility because it is not risk.

  • Volatility is the measured change in price.
  • Risk is the unknown probability of the investor losing money

These are completely different concepts, yet misunderstood by even the smartest of participants and commentators.

Why risk can't be measured by volatility

When you enter an investment, you face a series of known and unknown risks. Some of these risks can be hedged or insured away (e.g a property investor can insure against fire and damage). Most risks cannot be insured (e.g management or regulatory risks) – the only way is to avoid them completely, but this leads to another risk – opportunity cost. By not investing, you run the risk of loss of capital due to the hidden tax of inflation. But none of this can be reliably measured beforehand, as no one knows the future with certainty.

Notice the absence of price volatility in that discussion? And yet why the devotion to it by the investment industry in determining if an investment is risky or not?

Remember, risk equals losing money. Does it mean you lose money when your BHP shares are quoted one day at $44 and the next at $42? Only if you sell them at $42 (and if you bought them for a lot more) have you lost any money. What is being recorded is volatility, not a capital loss.

The point I’m trying to make is that some assets will have a lot of volatility, but in the end are low risk, whilst other assets have low or even zero volatility, but could be extremely high risk (e.g holding cash during an inflationary period). What’s important is when and how you make a loss and how you can mitigate that risk.

Lower the risk, higher the return
This statement goes against human nature – surely to get a big return, you need to take on large risks. As a full time trader I know this is a falsehood – I would be out of business if I took higher risks or if I eschewed volatility. For investors, the equation is similar – by lowering your exposure to the probability of loss – by either avoiding, mitigating or lowering your risk, the greater the chance of a positive return on and of your capital.

This is the current case for all the negatively geared property investors. They are exposing themselves to the ongoing real capital losses involved, whilst relying upon a seemingly low volatile asset class – i.e “property always doubles every 10 years”. This is an asset class that is subject to uncertain regulatory risk (e.g reversal of negative gearing legislation or increased CGT), uncertain liquidity risk (you can’t sell property like you can most shares) and other unknown risks (e.g deflating asset prices and rising consumer prices). Higher risk, lower probable return.

Risk Profiling is nonsense
Because risk cannot be measured reliably, and your “expected returns” are almost always undeterminable, the industry standard of “risk profiling” is a nonsense. The major problem is your behaviour as an investor- its very easy to be calm and rational whilst answering a few theoretical questions, but your responses may well change when answering a margin call or listening to your bank manager discuss your loan-value ratio on your investment property. This is borne out repeatedly in market crashes when even the most robust, well-managed and strong businesses are sold off, as even the most conservative investor runs straight to cash.

In my next article, I will contend that there are only two types of investor “profiles”, building on the observation and work of Benjamin Graham who formulated this idea well before the economic academics muddled generations of investors with “high growth”, “moderately balanced” and make navigating your yearly annual super statement a nightmare. I’ll also look at why the default option – used by some 80% of super investors – is actually extremely risky for the majority and should not form part of the MySuper campaign about to be introduced by the Federal Government.

(dumb) Diversification across asset markets doesn’t work
Here is Exhibit A and B, showing the correlation between diverse asset markets over the last decade (represented by a series of Vanguard mutual funds).

All securities, but bonds failed across all classes.

Diversification is purported to work based on the notion that you can create a portfolio of assets that have low or zero correlation with each other. That is, losses in one category should be offset by wins in the other category. You are “spreading” the risk, offsetting the chance that one asset may blow up, which can have dire consequences if you concentrate your portfolio (e.g like owning only one investment property).

But the real problem behind the diversification theory is that in a world of inter-connected fragile capital markets, an outcome of globalisation and widespread securitization of sovereign currencies (called a floating exchange rate), correlation is effectively the same. Australian shares behave like US shares, which behave like European shares, which behave like the Euro, which behave inversely to the US dollar, which behaves inversely to gold, which behaves similar to the Australian dollar and so on. In fact, during the GFC most if not all major markets experienced the same volatility going up and down, and it continues to this day.

For the investor, particularly within a large super fund, what’s the point of diversifying when all asset markets are behaving similarly? Why worry about being “overweight” emerging markets, or “underweight” commercial property, or “neutral” shares when there is little or no benefit in diversifying in any of them? Yet these are amongst the myriad of choices given when you select your risk profile. No wonder most (over 80%) go with the default option.

The standard industry doctrine claims that it is pointless trying to “pick stocks or classes” (or heaven forfend, try to time the market) and that widespread diversification is more effective. This type of dumb diversification sells because of the inherent complexity of trying to be a smart diversifier, i.e – to try pick and choose and concentrate where to allocate your capital.

Paradoxically, they are right. Could you have picked the best returns from these asset classes year in, year out?

It is hard, evidenced by the fact that most active (i.e stock picking) fund managers can’t beat the index, something I’ve covered here. Most super funds use a passive policy and invest heavily in index ETF’s (exchange traded funds) or create index following portfolios. Index adherents will point to the ASX200 and All Ords “average” growth over the decades as proof that this diversification policy fits well with a superannuant saving for retirement over the long term. More about this in a later article.

The slavish devotion to markets
My core problem with conventional asset allocation in the super industry centers on the premise that a diversified portfolio comprising mainly risk assets is necessary for almost all participants, and the inevitable risk asset chosen is listed shares. Share markets have become the place to allocate superannuation capital. The question is does this actually provide a net benefit to the superannuant or to the economy?

I’ll leave the second case to other macroeconomic analysts, but this leads me to my final point about the problem with current asset allocation dogma and to the first question raised in this post – if super is for saving for retirement, how hard can it be?

The average super fund has returned 3.3% over the last 10 years, whilst the ASX200 has averaged over 10% and fixed interest (using the UBS Composite Bond Index) has averaged 5.4% – this is the problem with flawed averages that I tried to elucidate in a previous post.

As Jeremy Cooper recently pointed out, since 1980 the All Ordinaries Accumulation Index has dropped more than 10% eight times – and each fall has averaged over 24% – which can have an irrecoverable effect on a portfolio heavily weighted to shares, particularly for someone about to retire. For those with a while to go til retirement, markets can also track sideways, even for as long as a decade, as shown in Q Continuum’s recent post.

American share investors have yet to return to their 2000 highs, repeating the 1968 to 1982 sideways move illustrated above. Don’t be fooled that it can’t happen here – the Australian market has already moved sideways for 5 years, unadjusted for inflation.

Its called saving, not speculating
The perception, that shares should be the No.1 choice for retirement purposes has resulted in a paradigm shift away from what should be at the core of super – fixed interest and other savings like investments.

Investing in fixed interest – e.g corporate bonds, government bonds, convertible shares and other debt securities – provides an economy with ready to go capital and equity for businesses to use to invest, expand and become productive. Yet as a proportion of super assets (excluding self managed funds), fixed interest and cash make up less than 25% – shares and property absorb almost two thirds of all assets, which goes some way to explain why super funds continue to underperform almost every other asset class in the last ten years.

In my next post about super, I’ll go over some different theoretical and practical ways to approach asset allocation.

Disclosure: The author is a Director of a private investment company (Empire Investing). The article is not to be taken as investment advice and the views expressed are opinions only. Readers should seek advice from someone who claims to be qualified before considering allocating capital in any investment.

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  1. Prince, these articles on superannuation deserve to be distributed far beyond macrobusiness. Any and every Australian with superannuation and at least half a brain would benefit from reading this. Top notch.

  2. Really good read. I’ve been reading things like this for a while and they are always eye opening. I really think I should move all my super in to the type of fund you talk about.

    What are your thoughts on putting your money in to things like shares (which do have a higher return but mean a lot more volatility and risk of loss) in the early parts of your career and moving slowly towards bonds and cash later on?

    The arguments I have read justify along the lines of, when you are young you have time to recover when you are older you don’t. What do you think of it?

    • Good question Matt. The industry is starting to catch up with the rest of the world and offer life staged products, but again, I think they are far too skewed to market based solutions.

      The arguments about recovery are interesting, but they ignore the concept of opportunity cost.

      A 30% drop, which is more likely to happen then anyone thinks, in your account at age 30 – with 30 years+ to go until retirement is an enormous opportunity cost.

      It can be “clawed” back – but you need outsize performance to do so, which implies good asset class switching and excellent market timing methods.

      I’ll go into how a younger (Gen X/Y early Boomer) can structure their super to take advantage of the upside of shares whilst preserving the majority of their super in my next post.

      • Prince — Fantastic post, and am in complete agreement with almost all of your points.

        However, I would question whether a 30% drop at the age of 30 is such a disaster. Just anecdotally, several friends of mine panicked during the market crash of 2008/09 and switched their 401k allocations out of the default option and into 100% cash. Of course they did this just as the market was bottoming and missed out on a 100% rally. Those who stayed calm and kept making regular contributions to the default option (which here is usually a target-date fund that gradually raises allocations to fixed income over the life cycle) are now miles ahead.

        I agree that there is a lot of room for debate on what a sensible default option should be thought. Looking forward to the next post.

        • I don’t believe there is a sensible “default” option. I think it’s more important to understand credit in guiding investment decisions.

          • There has to be a sensible default option (a truly conservative one), because the reality is, given the poor state of financial literacy, a lot of people will make very bad decisions about this stuff if left to their own devices.

            Quite a bit of interesting behavioural finance research has been done on this.

        • Thanks RA – I missed your comment before.

          I think your friends have had an easier ride – the Dow and SP500 have improved markedly compared to Aussie equities.

          But yes the caveat is if you are 30 years old and suffer a 30% drop in your super, its not as bad as being 60…. (or losing it to Storm Financial)

          The opportunity costs, mathematically, are far greater, but there are ways of recouping those returns if you do things differently…

  3. Thanks Prince – this is great stuff.

    Your comment at the end “The perception, that shares should be the No.1 choice for retirement purposes has resulted in a paradigm shift away from what should be at the core of super – fixed interest and other savings like investments” is looking about right.

    The super industry (i.e the finance industry) might just be wrangling out the last few bits of middle class savings that they missed during the property boom. Looked at in the light of ‘long-cons and squids’ it’s hard not to think that the key reason for the current asset allocation preference is that no-one gets great fees from cash.

  4. Outsidetrader

    Thanks Prince – another great article.
    Your chart at the end of ASX vs bonds vs super funds is very useful, and makes a very valid point about the superannuation industry.
    The suggestion that equities are a poorer option than cash in super funds is not due to the poor performance of the ASX relative to fixed interest alternatives, but rather due to the inability of fund managers to match the returns achieved by the ASX. I find it particularly sad that the chart shows that fund manager performance was weaker than both equities and fixed interest over the past decade (which leads one to question how bad their investment decisions must have been).
    The compulsory nature and complexity of superannuation means that indivuals blindly allocate masses of funds to the industry in a largely disinterested fashion. The result is that there is little incentive for fund managers to ‘beat the market,’ and instead they can ensure their own financial futures are secured by charging fees that are not aligned with the value that they provide their customers.

  5. Great article to put summary on modern approach to long-term investment. However, to be fair the MPT and EMH are not totally rubbish. They’re still elegant conceptual guides to understand how investment and market works in general (with certain qualifications).

    EMH in its weakest form is quite make sense and supported by fact in the long-term, asset price would more represents its value based on publicly-known information. That’s why as you already mentioned above that any individual will be hard-pressed to beat the market performance in the long-term (> 20 years). This is caused by speedy spreading of publicly-known information to the market (esp in internet and smart-phone era) so that it is hard to always use the information before the rest of the market similarly do so.

    Statistically speaking, it is even proven (by research in the US) that your asset allocation decision is the biggest factor determining your portfolio’s long-term return. That’s why people was encourage to think strategic asset-class allocation rather than detailed investment decision to individual asset(s).

    But, I agree 100% with your critical tone above in terms of the concept to quantify risk using statistical normal-distribution approach in the MPT. They’re just approximation but people should know that in the real world, there’s no such thing of normal distribution and fat-tailed / black-swan events sometimes ruined your portfolio’s return. And also as you said above, true investment risks are more than just past price volatility.

    One of the great advocate of MPT in the US (Will Bernstein, if not mistaken) is actually suggesting the same advice like yours that people should not discount the importance of defensive asset classes like fixed-income and cash in their portfolio and their importance in the portfolio should grow the older the investors are.

    Great and intelligent post as usual from MB team.

    • Important Side Note:
      The oft (and by oft I mean almost every second article) quoted research on determinants of portfolio performance have been misquoted so many times I can’t remember the last time I witness a correct description of such studies. The main one in question being the Brinson, Hood and Beebower study.
      This one in particular was very narrow in its focus, 80 odd US pension funds over a single 10 year period. THE ONLY CONCLUSION reached was that the selection of active managers for each asset class added almost no value over that time frame and that a market return for the given asset allocations would have returned better results. Anyone who understands the investment industry can tell you that straight up, as long as 90% of funds invest like an index, 90% of fund managers will only generate returns equal to that index less fees….. pretty simple concept that requires not a minute of academic attention.
      Over time and through the hands of various marketing departments these studies have manifested into the magical statement of ‘asset allocation accounts for 90-100% of an investors return’ As a blanket statement for all investment portfolios this is 100% WRONG WRONG WRONG! (although it is ironic for someone like Vanguard to trumpet the critical importance of asset allocation and then suggest that all investors need do is select 6 asset classes based on a few excel calculations and then ignore it for 10 years???).

      I’m not directly criticising Deo’s post here, merely bring to attention yet another piece of dazzling misinformation circulating the investment world!

      • Thanks for reminder BB, vested interest is always there to muddle the truth in any information given in the market. Yes, you’re right from what I gathered there was a few researches in the US and covered in various books supporting index investing and basically the “dogma” become popular by Vanguard ad saying the portfolio return is mostly (70%) determined by asset allocation.

        For me, it looks reasonable considering the reality you see at any share market on daily basis where most shares move in tandem with general movement of the index (i.e. most shares go down/up when the general index go down/up). But hey, as you said.. you need to take any information with a grain of salt, especially if it involves money.

  6. Excellent.

    BTW: “But the real problem behind the diversification theory is that in a world of inter-connected fragile capital markets, an outcome of globalisation and widespread securitization of sovereign currencies (called a floating exchange rate), correlation is effectively the same.

    since the emergence of commodity ETFs, since about 2006/2007 commodities are now highly correlated with equities too.

  7. I am looking at my latest super statement:

    “The Trustee is required by law to provide a statement of the compound average net earning rates for the Fund’s investment options for a 5 and 10-year period”.

    And so they do, but, how long has this legislation been around and how were annual averages decided upon? Should we be campaigning for indices on our super statements instead? I presume indices do more accurately reflect performance.

  8. The super industry, like financial planning firms can’t move with any real speed, which is why it’s all long-term time in the market stuff. Even those managers who may have suspected it was time to sell up and move to cash when the first signs of market jitters appeared could never have done so…’s just far too impractical (for them) and slow…..not to mention costly for the firms who accept kickbacks from the fund managers.

    • I thought the length was reasonable, or to put it another way it would have detracted from it if it had of been split.

      Having said that if it was more than say another 20-30% it might need to be split.

    • I’ve got no problems with the length. The longer the article, the more great information 🙂

    • The ghost of Lenny Hayes

      Length is irrelevant when the topic is of interest !

      Great stuff by the way Prince, as a late 30’s X’er it’s nigh on impossible to get this kind of fincancial insight as it relates to my age group.

      I’m really finding this stuff insighful, and it’s prodded me intellectually to take more of an interest in my personal financial situitaion, and not just be a “default” kind of guy !

      Keep up the excellent work.

  9. Prince

    Excellent article. No problem with length for me – I would be happy with longer articles!

    One question that I have for you is that I am interested in reading up on investment / wealth management. I have read “the Intelligent Investor”, among others, and I am currently reading “the Black Swan”.

    I would be very keen to get some suggestions from people in the know on some worth while financial literature…. Any tips?

    • Thanks Karlos.

      The quick answer is here:

      The books in the sidebar (Disclosure: linked to my Amazon account so if you buy them I get a few bucks) are the “core” investment books, IMO.

      I have almost 100 investment/trading books – most are just a good read or laugh, but some contain one sentence or paragraph that makes sense. A few like those above, are pearlers.

      The Great Crash of 2008 (Ross Garnaut/David Lwellyn Smith) is the best out of a diverse bunch explaining the GFC.

      The Black Swan is a bl##dy hard read, read Mandelbrot first. In fact, put it down now and get Mandelbrot!

      Debunking Economics by Steve Keen is also a great read, but a hard slog (maths are a bit hard, particularly for folks like Rory Robertson…..), he is coming out with an expanded second edition later this year (which will cover some macroeconomic concepts better).

      I might do a weekend book review on these. There are some trading books that are top notch as well.

      • Thanks!

        I actually went to your website and saw the books you recommended – Hence why I am reading Black Swan and I have ear marked the Mandelbrot book as my next read, so will definitely grab that! Over time I will also have a look at the other books on your list.

        I’ve actually nearly finished the Black Swan, it is a struggle in places (especially Part III).

        I look forward to hearing of any other books that you recommend!

        • Karlos,

          The prequel of the Black Swan i.e. Fooled by Randomness is actually easier to read and quite good too.

          I would recommend the classic “A Random Walk down Wall-Street” by Prof. Malkiel which is one of best-selling and most useful investment classics.

          Some quick-read guides for long-term investment can also be found in books from William Bernstein…the latest one is “The Investor’s Manifesto.”

          • Malkiel is an EMH advocate. Which is not to say you should not read him — best to read a diversity of opinion and make your own mind up.

            For a read about the GFC I don’t think you can go past “Bailout Nation.”

            Agree with you about fooled by randomness. Steve Keen’s book probably has more appeal if you’ve already studied economics at some level. Paul Ormerod is another that writes in a similar vain.

            “Where are the customers yachts” is a 60-70 year old classic.

      • Didn’t find The Black Swan particularly heavy going myself. Agree with you on Debunking Economics, though. I thought it fell between the two possibilities of a mainstream book for non-economists and a treatise for the economist crowd. Would have better to have edited out all the math stuff.

        Another very entertaining read on the GFC is The Big Short, which is written from the viewpoint of those few who saw the madness for what it was and profited hugely from it. Thomas Sowell’s The Housing Boom and Bust is good as well. He goes in to why the boom in the US was regional rather than nationwide and draws out a few other factors that would not be known to those unfamiliar with the details of US politics.

        • Yes, Alex..The Big Short is one of the best finance book on the US sub-prime topic which is easy to read even by reader with not much financial literacy.

          The other insightful soon-to-be-classic on the financial boom&bust topic is “This Time Is Different” by Ken Rogoff although it is a bit dry to read many tables and graphs about past financial busts 😉

          • The Rogoff book has an interesting title but before accepting what is put forward in the book it might be worth reading Bill Mitchell’s critique — which was particularly damning.

          • Yes I am aware of Bill Mitchell’s critique on it but not necessarily agree with it. Let’s say that I don’t share the same economical and political view of Bill Mitchell.

        • Thanks guys, I will make a list.

          Its good to get some recommendations.

          Has anyone read “private wealth management” formerly “personal financial management”?

          • rational investor

            Great article prince. I recognised numerous concepts from some of the great books as I was reading your article, I’ve never seen anyone summarize what has taken dozens of books for me to learn so succinctly and well.

            to the book club above, I recommend reading manias panics and crashes by kindleberger before this time is different. also of worth, particularly to understand what most instos do wrong (hence a lot of super funds) is margin of safety by klarman.

            again prince, great article.

    • Karlos

      If you want to balance up your reading list, in addition to “A Random Walk Down Wall Street” try these:

      “The Intelligent Asset Allocator” by William Bernstein

      “The Unbeatable Market” by Ron Ross

      “Winning the Losers’ Game” by Charles Ellis.

      I think they’ll save you a lot of money and time in the long run.

  10. The problem is where do you place your money?

    Govt bonds are guaranteed till maturity, but if long term inflation rises ?
    Foreign fixed interest ? – QEx
    Equities, property – everything comes back to the cost and quality of credit.
    Cash ?
    Tax paid yields of equities versus fully taxable interest yields ?

    Debt deflation scenarios – give preference to defensive stocks and govt bonds as well as cash

    Inflationist scenarios – shares and property.

    Each way bet – mediocre performance.

  11. A fantastic article overall, but there are a couple of things i dont agree with.

    Firstly, risk isnt just on the downside. There is upside risk as well connected to events which you need to think about.

    Risk profiling isnt rubbish, however it is often completely mis-applied. What tends to happen is that the risk profile is based solely on mathematical models (is VaR or t-VaR) which always fail when extreme events occur.

    If you use a qualitative application of risk profiling to a portfolio, you get a completely different outcome. So for example, if you brain-storm every wild and crazy scenario that could occur (not limiting yourself to what *has* occurred in the past, but including everything you can think of) you then have a pretty good collection of tail events that no model will pick up.

    You can then test the sensitivity of your portfolio to single events and combinations of events (and exclude diversification benefits, which also break down at the extremes).

    This kind of exercise shows you the clear pressure points in your portfolio, and is the type of risk profiling that is actually useful. It applies to all industries and even individuals.

    It can help you put together a portfolio that will perform reasonably well in most economic environments with far less vol than the typical high-growth allocation (ie getting the diversification aspect right so you dont have to touch the portfolio very much long-term). This would look very different to a normal super fund allocation.

    Another way of thinking is “what will break me?”. If you do this right, you can produce your own set of indicators that can help as early-warning signals for you to act on (not necessarily just for assets here, but for life events in general).

    of course, this is largely absent in super funds. They only care about peer group performance. As long as they arent worse than their competitors they are happy (which is vastly different from the interest of super fund members).

    On strategic asset allocation, it makes a huge difference to your performance (as you well know, since you advocate low-vol portfolios high in cash and bonds). Where losses often occur is in the tactical allocations and ranges of movement, essential a speculative part of the portfolio which tries to make a little additional return to beat the peer group.

    • Pete, historical Modeling, Stress testing and scenario analysis are in deed fantastic investment tools!

      But by ‘risk profiling’ I think he is referring to the retail investment industry practice of linking a few random data points like time horizon, volatility and experience with previous investments and linking this to “model” asset allocation.

      The kind of process that labels you “balanced” or “growth” and is 10% investment theory 60% investment sales and 40% institutional legal & compliance!

      • yep i did understand that (hence made the opening comments re risk profiling using VaR-type models), but i thought it was worth expanding the commentary to show how risk profiling could also be useful.

        Obviously due to the length of the article it couldnt be expanded on. The Prince knows this, but the readers may not, and sometimes broad-based comments get taken out of context.

        It was wrong of me to say at the start of my comment that there are things “i dont agree with”, its more accurate to say there were things i’d like to expand upon…sometimes the right wording doesnt come to you instantly 🙂

        The Prince, look forward to Part 2. I think 6 or 7 is on the low side given the explosion of options!

        Keen to see what your two types of investors are and whether it aligns with my thinking. I keep in my mind two broad types: those who are accumulating in their early years, and those who are defending in their pre-retirement years.

        I guess post-retirement is another, but that doesnt look much different to pre-retirement. (this may be coloured cos i’ve had variable annuities on my mind lately too!)

    • BB – well said, that kind of percentage breakup seems about right.

      Pete – your last paragraph is quite correct, which is why I advocate an asymmetric asset allocation technique, not the traditional “pie” style, with almost no emphasis on risk management.

      I’ll explain that in Part 2. And how there really is only two types of investors, not the 5 or 6 or 7 (what are they up to now? Moderately conservatively balanced?) that the industry thinks.

  12. Wouldn’t super have been generating the lowest returns because most people do pick the default option?

    What were to happen if everyone picked high growth Australian shares?

    • Exactly, “balanced” is anything but – it should be called “Extremely high risk” as on any measure (except during the middle 3 years of the last share market boom) it has underperformed pretty much every asset class there is, thus disproving the worth of diversification.

      SCM – there is a case for switching your options within super at certain times – most are now offering a “pure” Aussie share option which tracks the index 100%.

      This can be used effectively if you concentrate your efforts during a boom/rally and then completely get out during a sideways market (i.e last 2 years).

      I’ve been doing this with my mother’s super – she can’t get out of it (she’s a public servant – there is no “choice”) – so I switch her allocation around.

  13. I remember talking to a fund manager who had worked for Westpac about asset allocation. He stated that during the 80’s they were told they were underweight Japanese Equities. They reached their recommended benchmark in May 1989. They then spent the 90’s trying to get underweight Japan. In other words everyone uses a rear vision mirror in formulating asset allocation. The same thing happened in the late 90’s with international equities and a lot of the major super funds.

  14. Prince, I wonder if in your future articles you might go into the value of dollar cost averaging as an avenue of ameliorating big risk during the accumulation phase. Obviously this is becomes of less value the further you are into this phase, but I thought still worth mentioning.

    • PS I wonder if you could also share your thoughts on asset allocation for allocated pensions for those of us who are lucky enough to have indexed pensions as well.

    • Thanks Alex, I’ll be going over both – the DCA strategy in a future article, amongst other strategies to use to accumulate and manage risk, but asset allocation for pensions in the next one.

      DCA is a timing strategy and has a few advanced variations, particularly using vanilla options.

      I am wary of its use/marketing by the financial planning industry, because it encourages repeated, ongoing contributions, all of which usually incur an entry fee…….

      • Prince, I know that you’re not truly sold on the virtue of index investing due to their basic foundation on EMH.

        However, do you think whether it is advisable in your future “investment guide” article to mention the virtue of “low-cost” investment vehicle which is mostly come from indexation revolution started by Vanguard in the US ? In the US there are many more low fee managed fund options than here in Australia that can be used for DCA efficiently.

      • Deo, I’m not against index investing per se, but using EMH as the basis for ignorant and lazy use thereof.

        There is a strategy called “core and satellite” whereby you use a “core” of ETF’s (and Vanguard do have some good low cost products – I mainly used them when I was in the business) and a “satellite” of either actively managed funds or even individual stock picks.

        The US definitely has a wider market, but we are slowly getting there too. For example, you can now invest (only long) financial stocks, resources stocks, Small Ords, and of course ASX50 and ASX200 – even long USD or Gold in USD (not AUD).

        This is mainly because of CFD’s – which are banned in the US – thus the proliferation of long/short ETF’s available, over pretty much everything, and very very low fees.

        As our Empire Index contends, I don’t think investing holus bolus in the ASX200 or ASX50 is an efficient use of capital – e.g you are putting a position on Telstra or Aristocrat Leisure, or any number of “Poor” companies – but for the average investor who wants some exposure, at low cost, and an almost definite low return (without leverage), they are one solution.

        And regardless of semi-strong, semi-weak or anything other permutations of EMH, its disproven and finished, as the assumptions underlying it are easily falsified – it is not a scientific basis for explaining how markets work.

        Behavioural finance and fractal/reflexivity theory do a much better job. They are not used to explain it at a basic level because like the false application of supply/demand curves in basic economic classes, to disprove them at the beginning then puts all the intermediate and advanced economics and finance subjects (e.g Black-Scholes, MPT, CAPM) into disrepute….but as you say its an elegant way of describing it, but only as an “idea”. (which is why there is no “Law of Market Behaviour”)

        • Appreciate your comment, Prince. Yes, I myself think the core-satellite approach is more appropriate for regular people who don’t want to invest too much times getting to know the investment nuts and bolts knowledge.

          But, of course for people who want and can do more, trying to beat the market by applying sound investing principles is possible. The question is whether you can do it consistently for long-term. As you mentioned above, human beings are proned to emotional issues that are detrimental to their decisions about money / investment.

          Being a purely active investor (while possible to be successful) is a very difficult and dangerous road to take with risk of over-trading, disaster try to time the market and personal hubris from gain(s) in earlier time(s).

          But I really applaud your effort here both in Empire and MB. You truly try to educate general public on better ways in investing and on the benefit of having good financial literacy in life.

          Bravo to you and the others in MB team.

  15. Prince,

    Thanks for this great article.

    I agree with your general theme but have an issue with some of the points you have made. Unfortunately, I don’t have the time or space to give myself justice but let me throw a few nuances at you.

    1. I think the core ideas behind MPT can still exist without EMH ( which I agree with you, is complete bunkum). In order to accurately assess the risk of an asset, one should not look at that asset in isolation but rather how its returns covary with that of other asset classes. This is still valid today and the GFC proves it – If you were 100% weighted to oz equities, you would be feeling a lot more pain than if you had a portfolio that also included T bills, bonds, cash and direct commercial property. Thats obviously because these other asset classs are not 100% positively correlated.

    2. I agree that standard deviation of returns is not an amazing measurement tool for risk but it is a half decent approximation. Some of the problems with it depend on how you define risk – if you base it on the probability of losing your initial capital then its not great, but if you define risk as the chance of getting a return other that your Expected Return, then it is not too bad.

    You also made a comment that: “The point I’m trying to make is that some assets will have a lot of volatility, but in the end are low risk, whilst other assets have low or even zero volatility, but could be extremely high risk”

    You will need to show me some more data on this because i don’t think its right. Generally, the more volatile asset classes are the ones where you stand to loose more of your capital (your definition of risk).

    3. I think you are being a bit harsh on diversification. I agree that there is definitely some dumb diversification out there but you should not confuse the direction of price/return movements with absolute magnitudes. That is, during the GFC lots of asset class returns went south but they didn’t all fall by 50% like equities. The graph you showed are only listed equities all falling by the same rate, but there are plenty of asset classes that didn’t fall by this amount.

    4. So while diversification still works I certainly agree that it is becoming less effective. If you look at rolling correlations between asset classes over time you will see they are definitely trending up. That is because of the weight of money in the system looking for a home but also because of the incorrect application of MPT. Most super funds say they do it but they don’t. If you actually ran (historically or forward looking estimates)of ERs and SDs for each asset class, you would never get the allocation weights that super funds target. Those target weights are influenced by (mostly) US based asset consultants who bring the American love of equities with them. The weighting to equities is far greater that a proper application of the theory would deliver.

    5. I think one of the big drivers to the love of the equity has been the switch from defined benefit super schemes to accumulation based schemes. If you look at the asset allocation of DB schemes, it was always overweight fixed interest.

  16. Hi Prince,

    Good article.

    I have been interested in fixed interest and bonds for quite a while. But I find that they are not as easy to access in Australia as other countries.

    I’ve been looking at something like the AMP Invest Bond which seems to be some sort of master trust that you can allocate into other asset classes.

    Does anyone know of a good resource for bond investment and where you can get retail access to good quality bonds?


    Mr White.

  17. Prince great article, and looking forward to the next.

    I’m not sure where I saw it, but there is a graph, maybe on this site, and maybe you did it, and it shows fixed interest return vs ASX Index (not sure which one); fixed interest was winning. If I find the link I’ll post it. It might be rubbish so I open to any correction.

    However, one of the key reasons I started studying economics was my Super returns from a big Aussie provider was roughly 2% over a 16 year period. I never looked at statements as I was busy with a 80 hr a week min job, so my fault, but I know there are many like me who were working flat out to pay the rent etc., trusted the provider, and knew super was as must have, and it will be ok in the end. As I found out not so, and a new career came about.

    I manage my own SMSF now, and am doing very well so far.

    Thanks again.

    • …oh, and length was fine.

      I think you could get away with maybe a few hundred extra words, but not too much longer…and that being on the premise that you are trying to reach Common Joe as much as you are trying to reach Mr. Finance.

      If that’s the case, i think you’re hitting a decent middle road – let me know otherwise and I could give you alternative feedback!

  18. Dispelling EMH is actually quite simple….
    the theory states that modern markets are so quick to interpret public information flow and assimilate this into market pricing that its extremely difficult for individual participants to generate excess profits from that same information.
    In today’s world would anyone disagree with that……. no they wouldn’t. The market is extremely efficient in processing information, simple!

    Where it fails is the assumption that the ‘market’ has CORRECTLY interpreted all information and CORRECTLY reflected this in asset pricing, or in short “therefore price = value and the value is always correct”.

    This conclusion is a MASSIVE leap and NOTHING in the EMH study actually supports it??? How so many educated individuals fail to see this is a human phenomenon that I will perhaps never understand.

    Drawing such a conclusion from EMH is frankly akin to saying “well you can’t prove god doesn’t exist therefore he does” scary stuff

    • Unfortunately, that dogma pervades all through regulatory bodies, institutions, financial/economic departments.

      It’s hard to change even after it has been thoroughly disproved year after year after year empirically.

      Same with Value-at-risk (VAR) and other falsified and disproved risk management techniques, particularly those used by banking institutions. (the key being risk=volatility, which I won’t go over again).

      • VaR is the biggest worry i have for banks in Australia. Since Basel 2 allows the advanced approach i think they are vastly underestimating both probability of default and loss given default in their models.

        Unfortunately since we are following Basel 2, there isnt too much the regulators here can do about it. If the banks can demonstrate that their outputs are supported by sufficiently credible data and a ‘robust’ model according to Basel 2 then they get accredited.

        All that can be done is for them to add a stress testing layer over the top with stronger assumptions. But even then that information wont be made public so who knows what the stress tests reveal.

  19. Pretty good article for the most part, nothing terribly groundbreaking. I will comment on two things though.

    *Volatility is the measured change in price.
    *Risk is the unknown probability of the investor losing money.

    Well ‘Risk’ by that definition is your definition, relating back to the first of ‘volatility’, it is a conceptual idea to why ‘volatility’ is called risk by many practitioners.

    With perfect foresight, you would get no volatility, it would be priced perfectly at all times and pretty much track at an exponent similar to earnings growth.

    The volatility (should) occur usually do to new information that previous attempts of foresight didn’t, or were unable to foresee.

    The question to be asked it ‘why did you price it wrong in the first place?’ I for one will call this risk because regardless of whether one priced something too high (thus resulting in capital loss) or too low (emotionally it may be good to enjoy the upswing of the volatility), they are equally calamitous in the allocation of resources. Both are signs of a misallocation, and therefore ‘risky’. Essentially I, as well as many practitioners, will call this ‘risk’ directly because of this lack of foresight.

    The notion of ‘timing’ markets. I know this is a baton traders like to espouse, but there is so much literature that dismisses this notion. Traders are notorious for getting annihilated in one off moments.

    As has been paraphrased plenty of times before on this board, every thing works well, until it doesn’t. Again this is an issue with foresight. You are right, with perfect foresight, you would time the market, but one of Robert Shiller’s major pieces show that missing the reflection points (i.e. the highest peak or lowest trough) by 30 days will mean an investor will return 1% less p.a. than sit & hold. Compound this 1% over an investment lifetime and it is a serious deficit. History has shown us (to date) that Warren Buffet is the best picker/timer of assets, and he gets around 60% of them right. There is also major scepticism about his ability during bear market’s, and questioning how much beta he captured in his assets due to a rampant increase in the money supply finding it’s way into capital assets. Even he may be overtly rewarded due to the 40 year credit bubble that Steven keen talks about.

    It is all great to say perfect, or even good but less than perfect, foresight will capture superior returns. That’s not the point of a diversified portfolio. A portfolio is acceptance that as an investor, you have no foresight, you can not rely on foresight and therefore have to develop a plan that counts for the fact that no foresight will be used.

    This does not discount the need, or proper prescription, to invest in fixed interest assets. That’s more of a pricing issue relating to CPI targeting. Priced correctly that would revert to grater prominence in any investment suite, be they superannuation or not.

    I will however leave with one off Benjamin Graham’s views. To paraphrase, “there is no reason for the yield of a bond, and a share to be any different”. Conceptually he is correct, but that hasn’t been the case for 50 years. IIRC correctly in his ‘Intelligent Investor’, he did subscribe to a portfolio of 50% shares and 50% fixed interest, however when it comes to investing and the funds available at the end of that 50 year window, 50 years is a hell of a long time to be ‘wrong’.

  20. Have lots of issues with this article.

    But have particular difficulty with your take on the Efficient Market Hypothesis. When summarised as the proposition that the market’s view of value is “correct” (i.e. price=value), then it is a “straw man” that is easy to knock down.

    I know that Professor Eugene Fama, the “godfather” of EMH, would not support this proposition.

    But when:

    1. considered simply as the view that (share) markets quickly and effectively incorporate new information into prices and that the current price is the market’s best “guess” of value; and
    2. supported by robust academic evidence over long periods of time that the market is hard to reliably beat

    it becomes a much more defensible idea. It hasn’t stayed around in academia for almost 50 years because finance academics are stupid. Certainly, the GFC didn’t undermine it.

    To reliably beat the market, you need to think:
    1. the consensus view(which incorporates more than you or I can ever know) reflected in the price has got it wrong; and
    2. the consensus will come around to your way of thinking before something else happens to push the price elsewhere.

    Good luck!

    There seem to be growing numbers of “experts” taking cheap (and, often, inaccurate) shots at modern portfolio theory, in general, and EMH, in particular. Often, the agenda is justification for one or other form of active investment management that, generally, does not stack up under rigorous interrogation of the data.

    • I agree with you John, as I mentioned above that many individual investor / fund manager has “great expectation” that he/she will be the next investment sage/guru like Warren Buffet or Peter Lynch, etc.

      The irony is even Warren Buffet recognized that it is hard to replicate his performance record (which prob required not little luck factors) and suggested for mere mortals, it is still better to find low-cost and average investment return in indexing rather than making disastrous decisions trying to chase alpha premium.

      To be purely chasing alpha, it is highly risky approach. The more sensible way is doing “core-satellite” approach.

      Just my 2c.

    • “1. the consensus view(which incorporates more than you or I can ever know) reflected in the price has got it wrong;”

      Greed and Conflicts of Interest are also heavily incorporated into “market” prices and this is rarely accounted for in academic studies!

      The standard disclaimer is that market participants are mostly “rational”. Was pre GFC behaviour rational?? not in an absolute sense, but it was completely rational to the market participants that stood to make a fortune regardless of the outcomes of their actions? Does a consensus among these participants really = a markets “best guess” of value???

      To make the assumption that a consensus view is : :”most likely” right is ludicrous given what we all know about human nature and the conflicted structure of financial markets….

      I recently saw an interview with Mr Fama in which he was asked the question as to how markets priced mortgage instruments so wrong….. his response? The market didn’t really price them wrong, participants just lost the appetite for them. Really? and that kind of thinking stands as the basis for how we view capital markets? No wonder they operate as they do.

      • View of markets does not say they are “mostly right”, whatever “right” means. And it does not rely on people behaving rationally.

        Essentially, it just says that market price is an unbiased estimate of value i.e. 50% of the time it is too high and 50% of the time it is too low. At any point in time, do not know which of these will apply and there is no easy money for the taking.

        After a major event (like the GFC), it is easy to say that the market was previously too high and to identify spectacular winners, for whom it was so obvious. But there were also some spectacular losers, who before the event were seen as masters of the universe and thought market prices were too low – these guys don’t tend to stick around.

        I agree that people do all kinds of irrational things, both as investors and in life. But that doesn’t mean that markets are easy to beat or that mispricing is reliably easy to identify and profit from. A number of behavioural scientists and behavioural economists (e.g. Richard Kahneman and Richard Thaler, I think), who have identified many irrationalities that make people bad investors, have recommended that for most investors a broad market based, passive approach to investing is the best way to go.

        • I should Quantify here John that I am not trying discredit EMH in favour of supporting active management strategies, fund managers etc.

          What is frustrating about this topic is that EMH has been used by the financial industry to perpetuate the market issues we face today. A good deal of those spectacular losers you speak of were the ones championing less regulation and more risk based on the assumption that “the market will look after itself, there are a lot of smart people out there in the market so how can prices be wrong.”

          I am also not discrediting a passive investment approach. For the right type of investor it’s an appropriate strategy. I should also note that implementing a passive strategy is not as straight forward as the product providers (Vanguards) of the world would have us believe, once gain an entire topic in itself.

          What I am dead against is those that SELL a passive investment strategy, using EMH as (part of) their basis, only to leverage excessive fees and encourage excessive risk taking on behalf of their investors.

          • BB

            I agree with you. The market certainly does not always get it right. At the macro level, blind faith in markets was overdone and probably encouraged some unscrupulous behaviour.

            However, at the level of an individual investor, the relevant message from EMH for me is that it is very hard to reliably beat the market. Most people are better off not trying themselves nor believing they can pick people who can.

            The way to wealth for most of us is not going to be as “smart investors” but from working hard, saving and making sure that we don’t get sucked in by people who claim they are smarter than the market and they are going to let us in on their money making expertise!

  21. Top notch article Prince!

    Something I concur with is that there is always some element of randomness, luck, irrationality in price movements that the pundits try to explian scientifically…..An exercise in vain in my opinion…Market is what it is….

    Another postulation or assumption of EMH contends that expectations are homogenous or as you more aptly put it ALL investors are rational……It logically follows if everyone was doing the right thing then there wouldn’t be a market and it can only trend in one direction or the other……Experienced traders like yourself and Avid have pointed that out with market range-trading most of the time.

    EMH had its roots in humble objectives of attempting to explain market movements, but sadly what has come around to haunt is its ideological anchoring that it can explain it and overlooking the wide gap that exists majority of the time between fundamentals and expectations…..aka Value v Price

    • Hi I love your article. I am studying EMH for my MBA corporate finance course right now and also studied it decades ago in undergrad. I might not have studied it thoroughly enough but I think that it states that the reality is semi-strong form prevails in that not all information is reflected in the market price and therefore insider trading can make big profits.

      I also agree with some of the other guys in that some diversification can still happen between the classes, hence the range of returns if you don’t just buy the market indices.

      But then again, Warren Buffet tells you to buy the index if you don’t know what you are doing because like he says and what my finance lecturer says, most fund managers will underperform benchmarks and hence the market.

      For the other guy looking for bond funds, AMP is the worst. Everything that AMP touches I stay away from as far as possible as they charge high fees and their returns are nothing to brag about. If you go to or commsec there are a bunch of better performing bond funds.
      Challenger has the Bentham wholesale global income and high yield bond funds and theres the Credit Suissee Global income one you can invest via perpetual. They both have double digit returns. Of course, I am not giving advice and funds that perform good one year, usually dont do so again the next year but then again there is a mountain of research on this. However, one thing is for sure, AMP managed funds wont be best of any year in any category.