Asset Allocation: Is it Art or Science?
10/09/2007 12:00 am EST
Roger Gibson, president of Gibson Capital Management, told attendees that while his co-panelist, Harold Evensky, sees asset allocation as mostly art, he comes down on the science side of the equation—with one caveat. Gibson says the science is probabilistic, not deterministic, since you cannot expect reality to behave like scientific models.
He noted that many financial advisors have the misplaced notion that asset allocation will lead them and their clients to the Promised Land, which is just a naïve extrapolation from modern portfolio theory.
His philosophy is one of long-term, strategic—not tactical, asset allocation, as he doesn’t believe in timing markets. Gibson noted that a good asset allocation strategic plan must satisfy science, by making good economic sense, given the client’s financial resources; and then art, by using behavioral finance, creating a plan that must be consistently followed by your client and not abandoned during market extremes. Unfortunately, many clients are prone to abandon their strategies at just the wrong time, often incurring huge damages to their portfolios.
Once established, an asset allocation plan can be likened to passive management as your base, with occasional departures—very carefully thought-out exceptions. He issued strong warnings to advisors that market timing is fraught with dangers, and relying on the “skill” of timers is often just a matter of luck.
Harold Evensky, president of Evensky & Katz, agreed with Gibson on matters of market timing, noting that he trusts markets themselves much more than money managers. Consequently, he also advocates strategic asset allocation and passive indexing.
His disagreement with Gibson is on the role of science and art in a practitioner’s process. His company uses the classic Markowitz Mean/Variance Optimizer to guide the basic asset allocation process [to choose optimal portfolios for clients’ risk tolerance and also reduce overall risk through diversification—Editor].
He believes there are three decisions in investing: choosing the best managers, market timing, or strategic asset allocation. And like Gibson, he favors the latter.
Evensky stated that we live in a retail world, characterized by a low-return environment—two key factors in devising asset allocation. However, the clients live in a third dimension, accompanied by expenses and taxes, which the basic optimizer model doesn’t consider. Therefore, risk and return factors can vary widely.
He expects a portfolio composed of 40% fixed income and 60% equity to post real portfolio returns of some 7.8% annually.
The challenge to the financial advisor is to realize that small variations can tremendously affect the ultimate portfolio return. Therefore, it is in your best interest to figure out a more cost-efficient way to structure your clients’ portfolios to reduce taxes and expenses. He commented that even a ½% reduction in these costs could sometimes lead to an extra 20% gain in the portfolio return.
He noted that most advisors tend to focus on probability and forget the importance of consequences in the pursuit of big returns. He suggested that they stop chasing “alpha” (excess return over the market), especially in lower- return environments.
Evensky closed his discussion by saying asset allocation is science first, then art, because to be a great artist, you must be an extraordinary scientist. But the ultimate application of asset allocation is art, accompanied by luck, which must also be integrated in practices today.