The Dark Side of Asset Allocation, Part 1

That’s a rather provocative title don’t you think? How can I possibly say that a great good, like asset allocation, has a dark side? In this series I hope to demonstrate to you how asset allocation is actually one of the hidden sources of fragility in the global financial system. Yet, its pernicious effects are largely unexamined because of the concept’s universal acceptance as one of the best innovations in all of finance, and hence, in all of business.

Taking On Unnecessary Risk

In this first part I want to discuss the fact that asset allocation leads investors to blindly take on risks that they otherwise would not have. This is because thinking about risk at a portfolio level is very different activity than thinking about risk at the individual security level. When thinking about risk at the portfolio level, as Modern Portfolio Theory instructs us to do, we abstract and even ignore the individual risky characteristics of a security.

Said another way, when we ignore the absolute level of risk in a security and convert it to relative risk courtesy of correlation, covariance, and beta – the tools of Modern Portfolio Theory – then we obscure the underlying absolute level of risks. Case in point: the mortgage backed securities of the Great Recession. If individual mortgages, like jumbo subprime, had been evaluated individually these securities would, in all likelihood, have never been underwritten, issued, and purchased.

Yet, when we view a single asset as only one little tiny piece of a portfolio, not only do we obscure and ignore the absolute level of risk, we may even seek out such characteristics because of the way in which these securities complement others within a “diversified” portfolio from a mathematical point of view. In fact, this near cataclysm of the MBS meltdown can almost entirely be blamed on asset allocation being accepted as the dominant form of risk management. Ouch!

To be absolutely clear about my message, I am saying that asset allocation, because it uses mathematical measures of "risk" - things like, standard deviation, covariance, beta, and so forth - actually misses the underlying risk of an individual security. So, ironically, the idiosyncratic risk is put into the portfolio, unexamined in any way at all. 

Doubtless there are positive outcomes contained herein, too. For example, the ability to diversify risk via Modern Portfolio Theory may allow capital to be allocated to opportunities that otherwise would go uninvested. Yes, fully acknowledged. But notice the hidden assumption in this point. Namely, that an opportunity has individual merits, but that its risks make it difficult to gain buy order conviction. In other words, this thinking acknowledges a view of the security on an individual basis. Which is my point: thinking in terms of asset allocation, thinking only of the overall beta portfolio contribution of an asset, leads to outsized risk-taking.

Insurance companies, whose entire portfolio of policies are underwritten risks, think about risk in absolute terms, and not just in relative terms. In fact, when they begin to lose sight of the fact that certain risks should never be underwritten, this is exactly when they run into trouble and when the combined ratio soars over 1.0.

Deworsification

Within asset management asset allocation leads to deworsification as investors dilute their alpha-opportunity set with beta-worshiping over diversification. So, another pernicious effect of asset allocation is that the work done by active managers to identify and underwrite the purchase of individual securities is undermined when the portfolio management team keeps adding in unnecessary assets to diversify away “risk.”

When I was a portfolio manager of the Davis Appreciation and Income Fund we typically had 30-35 assets in the portfolio. Something that our third-party evaluators like Morningstar called “concentrated” – their polite way of saying that we were risky. Yet our retort was always the same.

We spent months and years evaluating the risk of these assets at the individual business level and the individual security level. In fact, we considered dozens of individual elements of risk when evaluating businesses. Among the factors was the quality of management, the ability of management to perform in recessionary times, the externality risk, the risk if the company could not finance its plans, and on and on.

Simply put, we did not purchase assets that we believed were risky. Implicit in this concern on the part of our third-party evaluators about a “concentrated” portfolio is that asset allocation is the only true way of removing risk from a portfolio. Bollocks! In fact, as this article should make clear, asset allocation actually leads to unnecessary risks being underwritten.

In conclusion, when you evaluate risk as an investor never lose site of the fact that individual securities carry absolute levels of risk, and not just risk at the relative level. My next article in this series will demonstrate how asset allocation impoverishes huge swathes of the world.

Jason A. Voss, CFA - Your Next Excellent Hire