The Quaint Notion of Asset Allocation?

I left off this blog an April 30th in order to help a friend who underwent medical treatment.

A few wide-ranging observations on the intervening period:

This friend is now my hero. In a few months, she persevered through more ordeals than most people I know face in their lifetimes. She is a happy, bright person. This could not have happened without the support of other friends who showed consummate tranquility, skill and optimism. My friend's sister helped her enormously because of her cheer, kindness, and gentleness far beyond my previous ability to understand.

So many people are dedicated to the good of others (or at least, more than we'd thought). I have never met so many people so driven and satisfied by helping other people. From the surgeons to the nursing staffs to the supply clerks at the hospital, I came away humbled. Equally true, I learned of qualities within some of my friends and family members that run deeper than I could have imagined. One family member told me, "This [helping my patients] is why I was put on this earth." We often don't learn these things about people until it's too late.

I have surpassing reverence for today's first-rate medical practice, and the science and people upon which it is built. If my friend had been in almost any other time or place in human history -- or even in another neighborhood nearby -- she would not have survived. Our capabilities as people are great, yet they are fragile because they depend on highly complex interactions between people, science, and society. We have achieved this in the last few decades after a mere 200-year period of industrialization, which is only a drop of time for the human species, and not a "norm" that should be taken for granted. We can lose all of this quickly if we not more careful.

Inquire (into everything) as if your friend's life depends on it. My friend's condition was poorly understood at first, rare, changing, and not consistent with any previous example. We inquired with everyone we could, dug up every case study we could, and listened intently to everyone -- especially the experts, but anyone -- because a tidbit from someone's life experience just might make a difference. (Now I'll start turning the discussion toward investing.) I think most successful people, and certainly great lifetime investors, do the same kind of incessant. I could have avoided a couple of investment mistakes this year if I'd asked more questions of people I remember starting conversations with.

Many truths don't last -- figure out which will and won't. The "truths" most people proclaim are mere lessons they can recall from the past few decades. In world changing so fast, these truths are not as useful as they were over the period of human evolution when we developed our brains' system for finding certainty. Applying this view to investing, I believe we can and must have a well-informed call on markets to supplement strict, mathematical asset allocation.

• Why is simple "asset allocation" now exposed as just a quaint notion? It holds that (1) a diversified investment portfolio that is (2) readjusted to keep proportions constant, results in (3) best returns over a lifetime. This "truth" of asset allocation became most popular in recent years after a 20-year bull market -- but this truth assumed we wouldn't experience a period when (1) almost all asset classes would lose value, (2) prolonged drops in value would cause investors to buy lagging asset classes far too heavily and too soon, and (3) best lifetime returns are always calculated over the most recent generation -- the times change with the generations, and a new one is always beginning (especially now).

Put another way, the power of thinking "what could happen" far exceeds the power of analyzing what strategies worked or failed in the recent past. Volumes have been written about how humans are pattern-making machines, with a bias toward believing the recent past will predict the future. Giving in to this bias can be devastating for investment returns.

Recognize and resolve your conflicting beliefs. In the hospital with our daughter, we appreciated doctors' conflicting views and interpretations of her condition and what to do about it.... and then we all used the information to choose a single treatment path. What seems self-evident in the hospital is often ignored in one's notion of his finances. Investors often don't confront their hunches, doubts and inconsistent strategies with a the goal of inquiring, researching, and resolving on action. Yet great investors do, as a habit.

The best investment book I read while standing by my friend in the hospital was Drobny's Inside the House of Money. Top global macro hedge fund managers discuss details of their investments, strategies, worldviews and daily approaches. It gets the mind working hard on current opportunities and risks.

The best personal investment book I read was The Retirement Savings Time Bomb, and How to Defuse It. Hardly any financial advisors -- and even fewer "investment advisors" -- bother with the make-or-break details of how your savings will be taxed when you're retired, and when you're trying to pass wealth to hears.

Where We Were Right and Wrong, And What We Think Today

Several of the observations listed above inform our next few words on picking up where we left off this blog on April 30.

1. We were right to be underweight equities and risky asset classes generally, and to be postponing the decision to fully "rebalance" underweight positions. And so far, we were right to say the financial crisis wouldn't run its course until the emerging markets experienced a financial crisis, which we believed (and still believe) would follow the U.S. and Europe's crises.

2. We were wrong to be adding to equity allocations, even though we remained underweight. We should have gotten more underweight equities, not less. We had all the information and the right hunches about the pending crisis, but trusted recent history too much to stay away from equities.

[Note: Even while we were, and still are, saying that an emerging markets crisis has to happen before we would consider the crisis fully in people's expectations, we were still creeping into equities. An inconsistency we should have stared in the face, because we think we would have stuck with our overall view, not bought equities here and there. There were other inconsistencies in our views that we rationalized instead of challenging.]

3. We were right to start discussing the role of absolute return strategies for individual investors. We were wrong to move slowly on this.

4. We didn't have our hedges ready at a moment's notice. Yet this is crucial because you don't want the cumbersome process of unwinding your core positions to cause you to procrastinate in making important decisions about your asset allocation.

So now, our most basic views are:

1. We remain underweight equities, waiting for a major emerging market financial crisis. China's GDP slowing from 12% to 8% does not satisfy this criteria. Nor does Russia's "bailout" of Iceland, or Indonesia's suspension of its stock market. We are also waiting for more financial institutions to fail as a result of the insurance on bonds (credit default swaps) that they sold far too much of -- and will be unwilling to pay off when the bond issuers default. Banks need to find out who will be bankrupted as a result of their CDS selling before they know who they can't and can lend money to. There is about $55 trillion of CDS outstanding, most of it insurance on the bonds issued by highly leveraged firms like Lehman, Washington Mutual, General Motors, etc.... so we think trillions more will need to disappear before we can say we're close to the bottom.

2. We may remain underweight equities for even longer than that. The crisis may not yet be half over, because: (1) $700 billion bailout pales in comparison to the risk of a downward spiral of asset values, and then there's that $55 trillion credit default swap market... (2) The U.S.'s efforts to save itself from crisis by spending trillions of dollars could boomerang, and cause a loss of faith for the entire dollar-based global complex. (3) International tensions could flare up during the economic deprivation that is coming the world's way.

3. We are about half our typical equity allocation now, signifying we expect a 1-3 year global recession, and at least some chance that banks' "confidence" could begin to heal in the next 3-6 months. We're still pretty bullish long-term (10+ years) given human innovation, information diffusion, and freer markets. But we think 20th century U.S. returns won't occur in any major countries in the 21st century because the pending environmental time bomb is beginning to weigh on business costs very broadly, and are also increasingly straining international relations given the quest for resources. A continued pullback in commodity prices could cause us to temper this view, at least for a single economic cycle.

4. We've got our shorts ready -- as a near-term hedge against our long-term equity holdings -- in case we begin to fear a further major pullback in equities.

5. We've got our buy orders ready just in case we see the conditions we're waiting for (see #1 above). Equity markets could quickly double off of much lower levels than we're seeing today, and some investors will capture the upside.