Some Light Reading

[Bob_Smith]

For those who enjoy getting under the hood, William Sharpe has posted some interesting observations about asset allocation and re-balancing. It's in three parts and it's quite long. I'm only part way through it:

http://www.stanford.edu/~wfsharpe/art/princeton/prince0.htm

He seems to be saying, among many other things, that the kind of re-balancing many of us do - restoring our portfolios to somewhat arbitrarily chosen fixed percentages (which is ultimately a contrarian strategy) - may not be the best way to limit risk. He also challenges the rationale for slice and dicing.

 

[Cut-Throat]

I had a little time this afternoon, and read the first 4 or 5 paragraphs and have got to admit that the writer did not suck me into his thesis.

His writing is not written for the average investor. There may be an important message here, and Bob, if you find out what it is, please let us know. I do not have the patience to. :-/

Please do tell us if you find any gold here.

 

[Bob_Smith]

If I understand him correctly, he is saying that we should not be re-balancing to a fixed percentage - we should re-balance to restore the global market weight of an asset class, which tends to drift over time. He's also saying that global market weights should drive our initial allocation decision, and that any deviation should be recognized for what it is - a bet on one sector over another (while also recognizing that some "home bias" makes sense). As I see it, he's just describing what he believes to be a way to reduce risk. It is purely academic, and there doesn't seem to be a practical way to implement his suggestions.

 

[Cut-Throat]

Bob,

Does he give any indication of what the Gobal weight of each asset class is? - Or how to determine the weight?

 

[Bob_Smith]

No he doesn't. He doesn't like the way people typically make asset allocation decisions, but at this point he seems to be introducing these concepts to investment professionals and academic types. He was one of the creators of modern portfolio theory and doesn't appear to agree with the way it has been applied. He's saying we should take a much broader view. But no specifics yet - I expect it will be forthcoming as it filters through to practitioners.

 

[Brat]

Ronin... there are some of us who switched from the physical sciences to math... the latter is easier (at least it was for me).

What I see is a hypothesis where all the steps in the proof haven't been fleshed out; rather like a number theory text I once had that was thin because the author would make great leaps with " thusly, " .... I loathed that text because the fellow was too cheap (lazy) to spend the paper to complete the proof.

Back to our Stanford professor, all mathematicians are philosophers at heart. They see a problem conceptually, and then they go out for a drink (or two) with like minded folks and kick it around (in my youth, on a napkin). In time the issues will be fleshed out.

 

[arrete]

there are some of us who switched from the physical sciences to math... the latter is easier (at least it was for me).

That's what my husband did. He said in the humanities you had to write papers and in the sciences you had to go to lab. In math you had to do neither.

arrete - hard science geek

 

[Hyperborea]

What I see is a hypothesis where all the steps in the proof haven't been fleshed out; rather like a number theory text I once had that was thin because the author would make great leaps with " thusly, " ....  I loathed that text because the fellow was too cheap (lazy) to spend the paper to complete the proof.

Reminds me of a joke about an engineering and a math student taking a course in making tea. They've been taught to make tea all the way from the beginning with all the steps.

They get to the final exam and they are given the situation where they already have a kettle of boiling water. The engineer uses the current state (boiling kettle of water) and finishes the making of the tea.

The mathematician throws out the boiling water and says, "Now we have a problem that we've already solved. QED."

 

[Cut-Throat]

No he doesn't. He doesn't like the way people typically make asset allocation decisions, but at this point he seems to be introducing these concepts to investment professionals and academic types.

I agree with this! - I did not like the way I made my asset allocation decisions either. Berstein did not really touch on this subject either. It just seemed like you took a stab at it, with no rhyme or reason!

 

[unclemick]

Looks like he's trying to prove DeGaul(and Bogle and Yogi) was right. Except this time add the whole world cap weighted Control costs(ala Bogle).

Tongue in cheek - just skimming - printed it out - but Sharpe is way worst than Bogle - he really,really loves his math.

Total US, Total International and watch the global cap weight. Never had the nerve to go there. Anyone who waded through the three lectures - feel free to chime in and correct me.

BTY - I have no idea what I just said - except thinking that super broad indexes would allow shifting of asset class weights within the index and minimize 'external' shifting and transaction costs. Anywise - need to read instead of skim.

 

[Bob_Smith]

I agree with this! - I did not like the way I made my asset allocation decisions either. Bernstein did not really touch on this subject either. It just seemed like you took a stab at it, with no rhyme or reason!

Yes, that nags at me too. We hear some general suggestions, usually via model portfolios, but the rationale is always thin or absent. Bernstein provided a few sample allocations, but no rationale for how he arrived at the percentages. He leaves the impression that he's just stabbing at it too.

And then there's the often repeated recommendation to go with a value tilt based on historical performance. Sharpe has said that doesn't necessarily make sense. We don't even know for sure why value stocks have higher expected returns than growth stocks. On that issue I thought Bernstein's explanation was sensible, but the rationale was thin nonetheless. And if one chooses a value tilt - how far do you go?

The main thing I got from Sharpe is that one should start with an allocation based on global market weightings (the ultimate efficient market approach), and any deviation from that should be done for a reason - and he does seem to believe that some "home bias" makes sense, and he allows for many other variables. But the way it's typically done now isn't always well thought out. He is essentially proposing a primitive framework to guide the decision-making process. And he's trying to bring that framework from the PhD level, to the advisor level.

 

[Nords]

Bill Sharpe has also said...

... that he's glad the Nobel Committee doesn't try to repossess their awards. (He was referring to his CAPM research.)

Sounds like he's trying to start a discussion (goal accomplished) but it also sounds like the debate needs to rage for another 6-12 months before there are any concrete conclusions.

 

[John Galt]

Speaking of "slicing and dicing", assume you all have heard the one about the guy with a strange compulsion
who worked in the pickle factory. If not
(and with sufficient persuasion) I will post it chop-chop

John Galt

 

[indymom]

OK, I'll bite. :

 

[REWahoo]

Indymom, you are on the cusp of learning that when it comes to John Galt, there are some questions you really don't want answered...

 

[Skylark]

Let's all hold hands and sing in unison:

"I'd like to teach the world to sing
in perfect harmony....."

 

[John Galt]

Well, the cheers of anticipation were less than
deafening, so I guess I'll pass. Anyway, I told it tonight
at dinner and got general polite indifference. Maybe it's
not as funny as I thought.

John Galt

 

[bruce1]

I would have bit but I was scared by the images brought up by slicing and dicing and may never have eaten another pickle

 

[indymom]

My children tell me I am soooo oblivious. Apparently they have a point. Oh well.

 

[John Galt]

Hello IndyMom! You know, ERwannbe has a point.
I have opinions on everything and absolutely no reservations about sharing them. That plus being completely non-PC tends to annoy others at times.
Anyway, I liked my pickle joke, but then I usually
prefer my own stuff. Not everyone is so inclined
as is their right

Hey, did you hear about the merger of Pillsbury
and Vlasic? They came up with a new product.
It's called Dill Dough!

John Galt

 

[indymom]

Never mind.......

 

[haha]

Hey, did you hear about the merger of Pillsbury and Vlasic?  They came up with a new product.

It's called Dill Dough!  John Galt

Definitely a LOL

 

[wabmester]

I did not like the way I made my asset allocation decisions either. Berstein did not really touch on this subject either.

What sort of answer are you looking for? I thought Bernstein was pretty clear on the subject -- he even recommends tools that will help you find the "ideal" allocation:

http://www.effisols.com/

Of course, what he doesn't emphasize is that the "perfect" allocation changes with time as the covariance of the assets change.

If you want to track what the "experts" believe is the perfect stock allocation on any given day, you simply need to own the entire market with a cap-weighted allocation. The cap-weighting is the market's way of telling you what percentage of each stock class is "right."

 

[charlie]

I've got most of my eggs in the "coffeehouse" basket.
Slice and dice large cap, large cap value, small cap
small cap value, international and reit in equal
weight but dilute with fixed income to suit your own
risk tolerance. Works for me.

Cheers,

Charlie

 

[unclemick]

Cap weight the world - how is the question. Doing it without costing too much(transaction costs) is the question. And like bonds - the utility function escapes my brain - I think I understand when reading - until I stop. Defining different investors mathematically is hard.

I think Sharpe is putting out challenges for new areas of research. Capturing changing co varience(and thus cap weight) on a dynamic basis might be possible in theory but not practical in the real world.