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Dancing to the wrong tune?

Investment management is based on a theory that may not always serve investors well

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By Brad McMillan

September 8, 2008 6:01 am ET

What could be more practical than investment management? You are your results — no excuses, no theories, just results.

And yet at its core, investment management is based on a theory.

Modern portfolio theory, with its mathematical exposition and underlying assumptions, gives shape to the uncertainty we deal with every day.

We dance to tunes written by others: Buy the market, hold over time, and you should do fine.

But what if the tune we are dancing to is the wrong one?

Robert Shiller thinks it might be. The Yale University professor and economist is best known for his book "Irrational Exuberance" (Doubleday Publishing, 2006), in which he called the peak of the stock market. To value the market, he used an uncommon analytical method, calculating the price-earnings ratio based on a 10-year average rather than on the trailing 12 months.

That is typical of an unworldly economist, you might say — except he followed the lead of the founders of the securities analysis profession, Benjamin Graham and David Dodd. This time, the economist followed the practical man.

Other practical men have taken note. Clifford Asness, founder and managing principal of AQR Capital Management of Greenwich, Conn., puts the 10-year p/e to work in a wonderful piece called "Rubble Logic."

STARTING VALUATIONS

It turns out that starting valuation levels provide interesting data as to subsequent returns.

Unsurprisingly, in this analysis, higher initial values will lead to lower returns over the next 10 years. So what could this mean for you and your clients?

It depends on whether you count on 10% returns for the equity portion of portfolios. As of the end of 2007, the 10-year p/e for the Standard & Poor's 500 stock index was in the 25 range; starting from there, the median annual return over the next 10 years would be -0.1%, according to Mr. Asness.

While there is wiggle room — and reasonable arguments to suggest that that may not be the case — the best results would still be much lower than 10% a year.

Of course, that is if the investments match the market. Many mutual funds underperform the market.

Moreover, many investors in mutual funds underperform their funds due to poor timing. Given this — and the reasonable range of market returns discussed in the previous paragraph — the average investor could end up essentially flat over the next 10 years and probably down.

Ouch.

So what can you do to help investors meet goals? There is no simple answer, but there are a bunch of good ideas, which in combination should help.

• Asset allocation rules. Investors should be diversified across asset classes, countries, currencies and time. Domestic stocks shouldn't necessarily constitute the backbone of the portfolio, bonds aren't a waste of time, emerging- and foreign-markets exposure is essential in equities and debt, real assets should be part of the portfolio, and alternative products are worth a look.

• Look at all sources of return. Dividends are important. Currency yields are important. Interest income is important. Price appreciation is important. Minimizing fees may be most important of all.

In a difficult environment, investors need every advantage they can get. Financial advisers will be more critical than ever in helping clients figure out what must be done, and then to do it.

So how can we do it?

First, look at asset allocation.

Domestic stocks might need to be reduced. For steady payments, bonds can act as a smoothing agent in portfolio returns.

International equities and bonds should be a core part of the portfolio, not a satellite.

The alternative piece may be the one that needs more focus from investment advisers. Most advisers and clients are sold on diversification among asset classes and even among countries.

Alternative investments, though, are still considered unknown and scary. The successful adviser will be the one who makes the switch ahead of the poor returns on U.S. equities that, if Mr. Asness is correct, will unroll over the next 10 years.

Last, get clients on board. They need to know that the world has changed and that past experience is no guarantee of future returns. The siren song of the long-term 10% return per year has been the refrain in investment advice over most of our careers.

Brad McMillan is the director of alternative investments at Commonwealth Financial Network in Waltham, Mass.

For archived columns, go to investmentnews.com/investmentstrategies.

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