Dr. Andrew Lo is a thought leader in the world of portfolio management.
The MIT/Sloan School of Management professor and Director of MIT’s Laboratory for Financial Engineering has been widely quoted on the implications of the 2008 financial crisis. One theme that Dr. Lo emphasizes repeatedly is that the risks associated with different asset classes can vary dramatically over time and for this reason, risk must be tracked, forecasted and budgeted.
In a world in which the risk of any given asset class (and therefore, also the risk of any portfolio of asset classes) can change dramatically in a short period of time, a passive buy-and-hold approach may, in fact, result in unacceptable levels of volatility.
Just so there is no misunderstanding, I will quote Dr. Lo:
Buy-and-hold doesn’t work anymore. The volatility is too significant. Almost any asset can suddenly become more risky. Buying into a mutual fund and holding it for 10 years is no longer going to deliver the same kind of expected return that we saw over the course of the last seven decades, simply because of the nature of financial markets and how complex it’s gotten."
Challenging Traditional Buy-and-Hold Strategies
This kind of statement from such an eminent authority should give everyone pause. And furthermore, Dr. Lo is not the only voice challenging the sensibility of a simple buy-and-hold dollar-cost-averaging approach.
Dr. Burton Malkiel, Princeton professor and author of A Random Walk Down Wall Street, recently proposed that traditional buy-and-hold asset allocations needed to be reconsidered in a recent op ed article in The Wall Street Journal titled, "The Bond Buyers Dilemma." (To read more on this article, see "Burton Malkiel: Buy Munis, Foreign Bonds and Dividend Stocks" in the related links below).
So what should investors be doing?
Lo proposes the following:
Your best bet is to hold a variety of mutual funds that have relatively low fees and try to manage the volatility within a reasonable range. You should be diversified not just with stocks and bonds but across the entire spectrum of investment opportunities: stocks, bonds, currencies, commodities, and domestically and internationally."
But wait a second, doesn’t this sound like ‘buy-and-hold’ albeit with a broader range of asset classes?
The key difference between Lo’s prescription and traditional asset allocation is in the advice to manage the volatility. The simple version of strategic asset allocation suggests that investors should buy-and-hold an asset allocation that changes only as an investor ages and/or as her risk tolerance changes. Implicit in this approach, is the idea that the aggregate risk level of any broad asset allocation is fairly stable.
Dr. Lo, by contrast, is suggesting that risk needs to be more directly managed. The risk level of the stock market increased dramatically from 2007 to 2008. As such, a portfolio with a constant allocation to stocks over this period also became dramatically riskier, and this increase in volatility was clearly predictable and, thus, could be planned for.
The good news is that risk can be managed using quantitative tools, a process that Lo refers to as tactical risk management. I prefer the more pedestrian term "risk budgeting." This might be a new idea to many advisors and individual investors, but this conceptual approach to risk management is a standard of practice in many institutional portfolios.
A Risk Budgeting Primer
The risk budgeting process is fairly simple:
- Create target risk levels for a portfolio.
- Design asset allocations to the target risk level.
- Periodically revisit the risk levels associated with the asset allocations and adjust the allocations if the projected risk no longer matches the target risk.
The asset allocations may be comprised of a series of low-cost mutual funds or ETFs as Lo suggests. The key new step in the process is to periodically measure whether the portfolio’s risk level is still consistent with your needs. There are objective quantitative methods for measuring trailing risk and for projecting portfolio risk. Lo’s key point is that portfolio risk must be measured and managed because the risk of any given asset allocation can vary dramatically through time. I agree with Dr. Lo’s points and the Target Date Folios that I worked with Folio Investing to develop apply this type of risk management procedure.
In a comment letter to the SEC in January 2011, Folio Investing offered the following observation with regard to the way that the volatility level (e.g. risk) of an asset allocation could change in time:
…during the bear market of 2008-2009, the correlations between many asset classes increased substantially and the risk levels of individual asset classes also increased. The actual risk in a specific asset allocation shifted substantially during this period, and it was better not to ignore these effects.
"In the case again of our own Target Date Folios, the substantial increase in correlations between almost every asset class during this period, led us to conclude that a wide variety of reasonable asset allocations had all become more risky, with the risk level of specific allocations to stocks and bonds changing materially. On this basis, we adjusted the asset allocation of the Target Date Folios to return to the targeted risk levels. While the percentage of a portfolio allocated to equities may have been viewed as a reasonable proxy for portfolio risk, the varying risk levels of different types of equities and the changes in risk over the last few years have demonstrated the potential downfall of such an approach.”
Risk Budgeting: A Sensible and Practical Approach
What Dr. Lo is proposing is sensible and practical. If the risk of investing in a specific portfolio allocation changes through time, it is simply prudent to change the asset allocation to maintain the target risk levels. Risk is not a stationary feature of the investing world. To steadfastly invest the same way, regardless of objective measures of risk does not make sense.
Dr. Lo goes so far as to suggest that it is irresponsible not to actively track and manage risk. In comments to the board of CALPERS, California’s enormous public pension, “When the environment becomes unstable, then it’s the height of irresponsibility to keep a static portfolio.” Of course, the challenge is how to do risk budgeting in an effective and cost-effective manner. I introduced this concept in an earlier blog post below titled, “Risk Budgeting: A Critical Tool for Portfolio Management,” for those readers who want to learn more.
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