Thursday, July 1, 2010

Asset Allocation and the Lessons from 2008 - Robert Arnott

As indicated earlier today on our Facebook Page we will incorporate more videos in our blog and on our FB page. This was one of the lessons we learned from a social networking and marketing webinar by Dan Garrella, a Boston-based specialist on this topic. What we like about Garella is that he uses empirical databases to arrive at his conclusions. 

In a similar way our first entry to the Asset Allocation Top 5 videos is an interview on Morningstar TV with one of the big guys in Investment Management who actually gained his reputation because of his excellent empirical research on markets. Robert Arnott is a hands-on market practitioner with solid academic background. His work on Fundamental Indexing is actually incorporated in the LMG Emerge Global Tactical Asset Allocation model.

In this video Arnott explains that 'structure' and 'approach' are very important when running an investment portfolio that is successful in the long run. Too often investors get caught in short-term panics. His 'The only thing that goes up in a situation of crisis are correlations' is indicative. And also: in that type of periods most investors tend to move away from things that are less familiar. And that is strange, but also bad news for Emerging Markets investors. Assuming that most investors know more about the well-followed big Western companies that are listed on Western exchanges that are characterized by the presence of tons of data elements about markets, stocks, market participants etc.

Now, although it might be logical to follow the bandwagon in this case, it is also understandable that a proper asset allocation is not helped at all by following this fear-driven approach. If you follow the masses and sell-off things you don't know and that allegedly are more risky, you will all end up on the buy side of the spectrum demanding treasury bonds, bills, savings accounts and gold. And indeed: in the Crisis of 2008 and its aftermath in 2009 those asset classes seemed to do reasonably well. AT FIRST.

But: as so often when we all want to enter a safe room via the same door we get hurt in the process since there is not enough space. Or when we demand the same item (with supply being relatively inflexible) the end result is that the items we sold get cheap and provide smarter, contrarian investors with nice opportunities to score good profits. That is what happened in 2009 when stocks rebounded: especially those unknown Emerging Markets stocks.

However, markets are still nervous. Arnott made it clear that you should stick to your risk budget and ONLY opt for a nice contrarian strategy involving risky assets when you still have space for it in your risk budget. And when your portfolio is hurt a lot because of a big crisis event, the likelihood of this risk budget being eaten away is larger. Therefore: we are still not there yet, with less favorable new information translating quickly into new fears.

Gradually but slowly however, markets will converse. Dragged out of the recession type environment. See for instance the tables on conversion from recession into moderate growth and into rapid growth (and vice versa) in our previous entry on Emerging Market Business Cycles.

We like Arnott's clear analysis since it made clear that we should not blame the calamities of the Global Crisis on Asset Allocation. If anything, it was improper Asset Allocation and Risk Budgeting by most investors that lead to the panics. Therefore: Arnott on Asset Allocation and the Lessons from the 2008 Crisis our number 1 entry in the LMG Video Top 5 on Asset Allocation.

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