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Joe Frazier was a feared boxer, a heavy-weight champion who, between 1971 and 1975 fought three momentous bouts with Muhammad Ali, winning once. In 1973, he fought a relatively inexperienced George Foreman in Kingston, Jamaica. Foreman had been a 1968 Olympic champion, but the veteran Frazier was a prohibitive favorite. The fight was no contest. Foreman knocked Frazier to the canvas six times, and ended the fight with a 2nd-round knockout. The legendary sports commentator Howard Cosell was at ringside calling the fight. As Foreman pummeled Frazier, a stunned Cosell, uttered this famous refrain (that is so legendary you can even buy as a ringtone for your cellphone):
“Down goes Frazier!
Down goes Frazier!
DOWN GOES FRAZIER!”
In the world of financial mathematics, a “veteran” financial formula has taken a similar beating as a result of the recent stock-market decline. Asset Allocation is a historical, mathematically-driven approach to investing that attempts to select investments from different asset classes to form a diversified portfolio, with the idea that the mix of investments will limit losses and smooth out returns.
At the mathematical heart of the Asset Allocation strategy is the matching of disparate asset classes – ones that move up when others move down, and vice versa. This disparity is quantified by using a correlation ratio; if two investment classes perform exactly alike, their correlation is 1, while asset classes that perform quite differently might have a correlation of 0.2. For most asset mixes in the United States, the benchmark asset class is the S&P 500 stock index, against which all others are compared.
Asset Allocation has a long history. It first appeared in the 1950s, and Harry Markowitz, a pioneer of Modern Portfolio theory, was awarded the Nobel Prize for his work. As Wall Street Journal reporter Tom Lauricella writes in a July 10, 2009 Wall Street Journal article (“Failure of a Fail-Safe Strategy Sends Investors Scrambling”), “asset allocation became ingrained in nearly every corner of Wall Street.” For over four decades, asset allocation was used in all sorts of financial products and delivered consistent, almost predictable returns.
But the last two years have not been kind to Asset Allocation. Lauricella notes that when the S&P 500 dropped 47% from March 2008 to 2009, many asset allocation funds performed even worse; their diversification didn’t work as a buffer against losses.
What happened?
The analysts interviewed by Lauricella noted two significant changes. First, globalization of the economy means greater correlation and less opportunity for diversification. The economy in China is connected to the economy in Europe, is connected to the economy in America – when they all act the same, you can’t diversify by investing in different regions.
Second, the popularity of diversification may actually make it a less useful strategy. As analyst Vineer Bhansali said, “when (lots of) people start buying an asset, the act of them diversifying actually makes the asset less of a diversifier.”
Money managers are divided about whether Asset Allocation is finished as a viable model. The value of diversification still seems logical and useful, so some adherents believe the process simply needs tweaking. But others see it as a relic of a past economic era – the “new” economy will require a different method of diversification.
But either way, there is a financial lesson that bears repeating: While events in life can be cataloged and categorized, life cannot be reduced to a mathematical calculation. This is especially true about the use of formulas to predict the future. There are too many variables that can change, and too many ways for the changes to be unforeseen. And just because something is improbable does not mean it is impossible. A primary objective of a good financial program is to adequately address all possibilities, not just those considered most likely.
