Tactic #1: Tilt from the Neutral, Efficient Starting Allocation

If you feel that you have superior insight to try to outguess the consensus view, then you can try to profit from your prescience. In other words, you can attempt to do better than the balanced asset allocation by expressing your market views. You can do this by overweighting and underweighting asset classes relative to the neutral allocation. Recall the neutral mix is what you would hold if you did not want to try to outguess the market. There may be times when you feel strongly that the market is wrong. During these periods you can express this view by tilting your allocation away from the neutral mix.

For instance, you might want to increase your allocation to equities versus Treasuries. If the neutral mix is 20 percent equities and 30 percent Treasuries, then you might increase the equities to 25 percent and decrease the Treasuries to 25 percent in order to express this sentiment. Each of these moves relative to the balanced portfolio can be considered a bet. You are making a bet that you know better than the market because you are moving away from the truly balanced allocation, which is agnostic to future economic conditions. Since both equities and Treasuries are falling inflation assets, you would only make this shift if you were confident that growth would be increasing more than consensus expectations. If this prediction comes true, then it would make sense that stocks would outperform their average return relative to bonds against their average return. In other words, you can express this market view by shifting the allocation from the neutral mix. The bigger the bet, the more significant your economic positioning. You can tilt more if you are more confident that you know the future. If you guess right, then you would likely outperform the balanced portfolio allocation; if you are incorrect in your forecast, then you will underperform the balanced mix.

A reasonable question you may be asking is the potential negative impact of rising interest rates on a portfolio that has a majority invested in fixed income investments. In general, rising interest rates pose a headwind for fixed income because the higher yield makes existing bonds less attractive and therefore results in principal loss. You might therefore argue that today a lower allocation to Treasuries and TIPS is warranted.

This simple logic, although seemingly intuitive, completely misses the point of having a well-balanced asset allocation. Because the portfolio is balanced, it is actually expected to perform about the same whether interest rates rise or fall. The same question should be asked when stocks rise or fall. Rather than be worried about the outcome, the key is to understand what kind of economic environment would cause interest rates to rise. You can diversify against the cause by owning asset classes that are biased to outperform during the same environment. If you focus on the outcome instead and try to protect yourself against that scenario, then you risk exposing yourself to another outcome because this approach will take you away from good balance. The protection comes in being balanced, not in avoiding the asset class you expect will perform poorly.

Following this logic, if interest rates rise due to strong growth, then Treasuries and TIPS would both likely underperform, but stocks and commodities would be biased to provide above-average results. If, however, interest rates rise due to rising inflation, then the outperformance of TIPS and commodities would likely offset the downside of Treasuries. Note that TIPS bonds may actually be a positive contributor if it were inflation that caused rates to rise because of the inflation component of these securities. These inflation hedges make up half of the fixed income holdings of the balanced portfolio. It may look like Treasuries lose in either case. However, if rates do not rise as much as priced in or if they actually fall, then Treasuries would provide a much-needed boost. This is precisely what happened from 2007 to 2013, when most investors had assumed interest rates were going to rise because they were so low relative to historical levels. Since the portfolio is well-balanced, then the losses from Treasuries, TIPS, or both would be offset by the outperforming asset classes to roughly net out at the average excess return from all asset classes, just as would be the case if interest rates fell.

Consider also that imbalanced portfolios (such as 60/40) may actually do worse than the balanced portfolio during rising interest rate periods because they are underweight inflation hedges. If inflation rises, then both the 60 percent and 40 percent components would likely underperform. This is exactly what happened during the 1970s as stocks and bonds underperformed inflation. The 60/40 portfolio suffered devastating negative excess returns for over a decade with severe drawdowns and extended recovery times. In contrast, the balanced portfolio (as summarized in the chapter on Treasuries) outperformed 60/40 by a meaningful amount. The 60/40 portfolio may do well if interest rates rise due to strong growth because of the overweight to equities. However, the results will depend on how inflation plays out. If inflation also rises, then that would pose a headwind because neither stocks nor bonds are great inflation hedges.

Another common concern with the balanced portfolio relates to the specific asset classes that I have used. Some experts have argued against the assumption that all of these asset classes offer a risk premium. In other words, some think that even though there is risk of loss from investing in an asset class, it does not guarantee that there is an excess return available to investors. If this were true, then there would be no benefit from investing in the asset class, since the main objective of the balanced portfolio framework is to capture risk premiums as efficiently as possible. If there were no risk premium to capture, then allocating to that asset class in the portfolio would not be advantageous.

In particular, there are concerns that commodities may not offer a risk premium looking ahead, even though this is a very risky and volatile asset class. The argument is that the number of speculators has vastly increased over the near term, effectively eliminating all the future excess returns of this asset class. Commodities are a unique asset class because this real asset is normally accessed using financial instruments, which can arguably be considered a zero sum game. For every winner there is a loser, because each transaction is technically a contract.

There is no clear answer to this question. The data still supports the existence of a risk premium because commodities have produced excess returns above cash over the near term. Furthermore, there is nothing unusual in the return patterns of late given the economic conditions that have transpired (falling growth and falling inflation—both of which are negatives for commodities) and the types of returns you would expect during such environments. It is very possible that opponents of commodities have simply mistaken poor recent returns as a flaw in the asset class rather than the more plausible explanation that it has predictably underperformed because of the occurrence of an unfavorable economic climate. Finally, the long-term excess returns above cash are relatively small to begin with. Despite the relatively low returns, the benefits of diversification and the fact that the positive returns come when you really need them still provide a benefit to including this asset class.

Throughout this book I have reinforced that the key takeaways are the concepts, not the specific investments provided or historical returns. Whether you agree with the argument that commodities, or any of the asset classes for that matter, no longer offer a risk premium is immaterial. If you don't like an asset class, then don't include it in your balanced portfolio. However, you will need to find another asset class that you think will cover the economic environments covered by the asset class you are excluding. It is the exposures that are key. If you can't find another reliable inflation hedge like commodities, then you may need to include it in your portfolio even if you don't favor it at present because it at least is biased to benefit you when you really need the protection.

Even with these caveats, should you decide to proceed with tilting away from the efficient allocation you can efficiently implement any active bet with the use of index funds. Since you are trying to add value by shifting the asset allocation, the application of this gamble comes from the difference in allocation. Thus, you are able to maintain a low cost, tax efficient portfolio and still try to add value over time by opportunistically shifting the asset allocation.

One notable implication of this analysis is that any asset allocation that is different from the efficient neutral allocation is effectively making a bet on a certain economic outcome. This is true even if the portfolio holder is unaware of it. For instance, if you think you are invested in a balanced portfolio and your allocation is the conventional 60/40 mix, then you are misinformed. The 60/40 allocation is a clear bet that economic growth will outperform expectations and that inflation will come in less than what is discounted. This fact can easily be observed by studying the environments in which 60/40 has outperformed historically.

Observe the Golden Rule: Diversification Always Trumps Conviction

One critical point should be made about shifting the allocation away from the balanced portfolio. The benefits of diversification are intuitive, reliable, and time-tested. It is not a zero sum game to hold a well-balanced portfolio because this concept only relates to capturing the excess returns of asset classes that are dependably and easily available. Everyone can do it and everyone can similarly invest in the balanced portfolio without detracting from anyone else. There does not need to be one loser for every winner. Due to these virtuous attributes, you should always observe the golden rule of investing: Diversification always trumps conviction. You should have greater confidence in the benefits of diversification than in your individual investment convictions. You might be convinced that Treasuries are the worst investment you can make. Notwithstanding this conviction, you should not underweight Treasuries relative to the efficient, neutral starting point too much. Your conviction that Treasuries are going to perform poorly is another way of saying that you don't expect growth to fall less than or inflation to rise more than discounted. Since you know that these outcomes occur about half the time, it appears foolhardy to feel so confident. Moving away from neutral is fine, but you should not veer too far away. How much is too much? There are no clear answers; however, moving your allocation to zero is certainly too far. Arguably, cutting the allocation in half may even represent too large a bet. As obvious as this may sound, most investors take active positions that are much more significant than what I am suggesting here. Not only is their starting point imbalanced, but they often take even bigger positions relative to this inefficient starting point than proposed here and are surprised when their portfolios experience excess volatility and underperformance.

Some professionals approach the asset allocation decision from a very different framework. They choose to invest in undervalued asset classes and avoid unattractive market segments. This approach may sound intuitive to those not trained to think in balanced portfolio terms. The problem, as you know, is that the asset allocation is most likely going to end up highly imbalanced. One way to reconcile these approaches is to start with a balanced portfolio as the neutral starting point. If you conclude that every asset class is fairly valued, then you would simply hold the balanced mix. If you have viewpoints that you would like to express in the allocation, then you can over- and underallocate from the neutral mix. And, of course, you should never allow your conviction in any area to trump the diversification of the asset allocation by significantly overweighting one or two market segments. Again, you should think about the economic bets you are making rather than the attractiveness of each individual asset you are buying. This is because of the appreciation that fundamentally each asset class is merely a bundle of economic biases and it is the cause-effect relationships that are most reliable through time. And, most critically, each asset class plays a role in the total balanced portfolio.

Tactic #2: Use Active Managers to Try to Outperform the Market

Another approach that you can adopt to try to do better than the balanced asset allocation is by using active managers to implement your portfolio. This is in contrast to using passive index funds to gain exposure to the various asset classes. A passive strategy typically refers to index funds. They are passive because of the lack of trading in the fund. The objective of index funds is merely to match the market, be it the stock market, bond market, commodities market, or some other market. Since the constituents of these markets do not change often, the index funds that track them buy and sell positions infrequently. Therefore, index funds are typically low cost and tax efficient.

Active funds, on the other hand, move around because they are vying to repeatedly buy low and sell high. Some funds do this by focusing on which holdings are in the indexes they are trying to beat and how their portfolios relate to these holdings. Others ignore the index and attempt to outperform over time by buying assets that they deem attractive and avoiding those that appear unappealing. Because of all the movement, these funds tend to charge higher fees and be less tax efficient than index funds. Additionally, the underperforming active managers eventually go out of business, leaving the ones with promising track records from which you must choose. This survivorship bias may make it seem that picking tomorrow's winners is easier than is really the case. In truth, a large percentage of the survivors owe much of their success to luck rather than skill and therefore may not achieve similar outperformance in the future (after you hire them).

If you choose to try to add value by using active strategies, then you would simply take your balanced allocation and implement each asset class using an active manager. For instance, if you have 20 percent allocated to global equities, then you might select one or two global equity managers or funds in which to invest this segment. With this approach you are taking the risk that the managers will do worse than the low-cost, tax-efficient index fund you could have used to nearly guarantee a market-like return. If after fees and taxes your active strategies do better than their respective markets, then you will outperform the balanced portfolio, even though you maintained the exact same allocation as the neutral mix. In other words, you can simultaneously hold a balanced mix of asset classes and use active strategies. Thus, your asset allocation may be balanced, but you may achieve an implementation advantage if you successfully select managers who possess skill in outperforming their respective markets. Conversely, you may still underperform the balanced portfolio because of an implementation shortfall.

As was the case with an active asset allocation decision, the use of active managers is also a zero sum game. For every manager that outperforms their market, there is another that underperforms. Adding up all the active strategies and funds results in a net negative, net of fees and taxes. This is because all the holdings make up the market, and since fees and taxes are taken off the top, the net result is less than the market by the amount of the fees and taxes. Since this is a zero (or negative) sum game, you should recognize the risk of using active managers to implement your balanced asset allocation. To be successful you need to have skill in finding managers who, in turn, possess skill. About half of the managers outperform the market over time. To add value to the balanced asset allocation, you need to find the half that will outperform in the future. Just because they outperformed in the past does not guarantee forward-looking success.

Tactic #3: Use a Combination of the Two Approaches

A combination of the two strategies just described may also be utilized. You may shift from the neutral mix and implement the portfolio using active managers. You may also combine the use of active funds with passive funds in implementing your portfolio. That is, some market segments may be more efficient (such as large capitalization stocks and TIPS) and therefore warrant the use of index funds along with their low fees and tax efficiency. Others may be less efficient (perhaps small capitalization stocks and commodities), which provides the manager with greater opportunities to outperform net of all added costs.

Note, however, that since you are combining two forms of value-added strategies, you stand a chance of either really doing well or falling significantly below the neutral mix's results. This is because both value-added approaches may not work simultaneously and detract value. Consequently, if you take this tack, you might want to temper your bets on both sides. In other words, you might take smaller active bets on the allocation and use fewer active funds in order to observe the golden rule of investing: Diversification always trumps conviction.