Much of the conventional wisdom about investing has been predicated around the notion that purchasing indices of risky asset classes are optimal and provide the best way to generate a return over the long term. Such wisdom became common place and moved mainstream during the 1980's and 1990's and was further supported by academic theories. The widely held belief was that markets are efficient and indexing to benchmarks always provide the greatest return for a given amount of risk. The other notion has been that over the long term, risky assets will always perform better than safe assets like government bonds. Therefore, simple diversification and occasional rebalancing would be the way to manage risk in an otherwise passive portfolio. If it worked in the past, we can extrapolate into the future, so the theory goes.
These days, there is much discussion about the implications of such conventional wisdom. The new reality in today's markets and economy can be stated as anything but conventional. A series of bubbles and crashes have generated high volatility in both the markets and economy, with little or no gains for well over a decade. At the same time, safe investments have outperformed riskier ones. The ultimate question is whether the financial crisis was just a perfect storm of events and eventually the markets will revert back to expected long-term return rates, or if we are entering a cycle where high volatility, high asset class correlation, and lower expected returns will be the norm. And if we have entered a new cycle, how long may it last? What will be the impact on the conventional wisdom should this new reality prove to be true?
If we look back in history there are long periods of time with high volatility and sub par returns - 1930's into early 40's, mid 1960's into late 70's, and the year 2000 until now. The bursting of asset bubbles, especially when induced via credit expansion, are usually followed by periods of higher volatility and sub par returns until the excesses are out of the system. In addition, the negative societal mood after such events usually impacts and shapes the way people feel about the economy, government, and the markets. In result, post-bubble market scenarios create serious challenges to the traditional asset allocation framework and expected returns associated with these models. A lesson from history shows us that asset classes can go through multi-year periods where the risks of holding the asset is not adequately compensated via the actual return achieved.
So what is an investor to do? One lesson we can take away is that allocation must rely on a top-down macro approach (what is happening from an economic, political, societal standpoint) in selecting asset classes which are most undervalued. Identifying undervalued investments requires experience and the ability to look beyond conventional market wisdom at the moment. Detailed analysis of market cycles and human behavior can be used effectively in determining the tactical asset allocation. The levels of entry and inevitable exit of an investment will be critical, although it shouldn't be confused with market timing. The process should be viewed as an essential component of risk management in a high volatility period where it could be more warranted than in decades past.
