The Asset Allocation Question

For years, many of the most trusted experts in personal finance have instructed American families to allocate their savings to a mix of stocks, bonds and money market instruments. The percentage that should be allocated to each sector, according to widely accepted theory, mostly depends on the investor's age, wealth, willingness to accept risk, and expected future income stream. But one factor has been conspicuously absent in the determination of investors' asset allocation decisions: valuations are not considered. If stocks are bubbly and bonds are cheap, the investor still funnels as much money into stocks as he would if the valuations were reversed. Two assumptions that underlie this approach to investing are that markets are generally efficient (meaning stock and bond prices are close to fairly valued given the amount of information available to the investing public) and that the average investor cannot beat the market.

Recent events have got me thinking a lot about this. This approach has wreaked havoc on the retirement savings of millions of Americans. So I took out a book I had not read since college: "A Random Walk Down Wall Street," by Princeton economist Berton Malkiel. The book is one of the most influential arguments for the efficient markets theory and the implications for personal investors. The basic message is that investors should not attempt to pick stocks or time the market.

Most of the research I have seen supporting the efficient markets theory (and the notion that the average investor cannot beat the market) focuses on the futility of stock-picking. "A Random Walk Down Wall Street" is no exception. It convincingly argues that people should not attempt to pick which stocks will go up and which will go down; they should just buy index funds with low fees. A small number of experts keep stock prices in line and earn profits doing so; but most people should not attempt to beat the market.

However, Malkiel only touches on the subject of asset allocation. Malkiel cites data showing that equity only mutual funds hold a larger percentage of their funds in cash (mutual funds almost always have a fraction of their funds in cash to meet liquidity requirements) at precisely the wrong times. He concludes that "mutual-fund managers have been incorrect in their allocation of assets into cash in essentially every market cycle during this period [1970-2002]." This is a weak argument. Equity only mutual fund managers are not in the business of allocating assets between equities and cash (and are often legally prohibited from investing significant amounts of money in bonds). They are in the business of buying stocks.

Consider the state of affairs in the United States. The vast majority of Americans and institutions invested a relatively fixed percentage of their savings into equities regardless of valuations. Despite the advice of people like Malkiel, a lot of that money is invested in funds with flexibility to pick stocks (as opposed to index funds). So, there are a lot of dollars out there chasing "cheap" stocks. Because so many people are chasing the same cheap stocks, it is very difficult to outperform the maket. But very few funds are able to sell stocks and buy bonds. Most of the money is literally stuck in the equity markets because investors believe they need to allocate some fixed percentage in stocks. There might just not be enough money out there that is actually managed by people with enough flexibility to keep stocks at fair levels relative to other asset classes.

I suspect that the very good research about the efficiency of the stock market has been wrongly applied to asset allocation in general. Although it may be difficult to pick which stocks are winners, it may be possible to intelligently allocate more or less money to certain sectors of the financial markets based on valuations like yields and P/E ratios. Much more research needs to be done on this point. But many studies have suggested that simple metrics like P/E and P/B ratios can be used to beat the market.

For years Americans have been instructed to invest with a blind faith in the ability of the stock market to turn money into more money when given a long enough time horizon. Recent events ought to at least trigger a serious academic reevaluation of the notion that Wall Street is able to keep the markets near their fair values. Perhaps it is time to rethink the philosophy of investing so much of our savings in the stock market regardless of fundamental valuations.