Charles Rotblut will speak at the 2015 AAII Investor Conference this fall; go to www.aaii.com/conference for more details.
David Darst is a managing director and chief investment strategist of Morgan Stanley Smith Barney. He is also the author of “The Little Book That Saves Your Assets: What the Rich Do to Stay Wealthy in Up and Down Markets” (John Wiley & Sons, 2008). I met David at the CFA Institute Conference in May and spoke with him shortly afterward about asset allocation.
—Charles Rotblut, CFA
Charles Rotblut (CR): Can you explain why investors need asset allocation?
David Darst (DD): Well, I think this goes along with AAII’s mission and purpose. Nobody would try to operate on themselves or rewire their home, unless they had full-time training and experience. And I think that the point of asset allocation is to reduce risk. That’s one of the keys of my personal investment philosophy, which comes through in my book, “The Little Book That Saves Your Assets” (John Wiley & Sons, 2008). Asset protection is paramount. People work like crazy to get a little money to invest. You need that to grow to preserve purchasing power, but at the same time, you’ve got to have some defensiveness and some protection. So my asset allocation philosophy is made up of four very simple tenets.
First, asset protection is paramount.
Second, correlations are critical. That means that it does no good to have a bunch of things in your portfolio that all move together in the same way. I think I mention in the book that guys will come in and say, “Look at my portfolio,” and they’ve got airlines, trucking stocks, restaurants, McDonald’s … and if the oil and gas prices go up, it hampers all of these stocks. They’ve got hotels in there, and they think they’re diversified! So correlations are critical.
Tenet number three is reversion to the mean. That means that if something has done well for 10 years or longer and starts to become too large a part of the portfolio, it’s important to look carefully at it. Like tech stocks in the late 1990s, or real estate stocks (I’m talking about the home builders) in 2005 and 2006. And if something’s down for a long time that is quality, it’s possible for it to stay down for a long time and still stay down. Exhibit 1 on this list is Japanese equities.
But if something’s down for a long time, you might want to take a careful look. One example would be the global gorillas, these great American companies—as well as Swiss, British and Canadian companies—that sell into the emerging markets, but because they’re in the local markets that have done so poorly for some years, they are not selling at extremely high valuations.
And the fourth tenet is the intersection of fundamentals, evaluation and psychology as the three drivers of asset prices, no matter what and no matter when. I know I mentioned this in a very brief fashion when we were on the panel at the CFA Institute Conference in Chicago. I think the point of asset allocation and diversification for individuals is that it’s very hard to be an expert—you need to have a good strategy and you need to have a good long-term, thoughtful view of yourself. What kind of risks can you take? What is your time horizon? What will you do if things go down—are you going to panic? The long-term returns from stocks are 8%–9% plus, but because of our inability to sit quietly in a room (which is something that the French playwright Molière said), we tend to buy at the top and sell at the bottom. And you’ve probably seen the numbers that indicate that doing so reduces the actual realized returns for many people’s stockholdings over the years to about half of the quoted return.
So those are some of the reasons for and, I think, the intended benefit of having diversification and of having an asset allocation approach to investing.
CR: I know a lot of people right now are more concerned with asset protection than asset allocation.
DD: You’ve got it! I’ve never seen systemic concerns like I have today, on all levels. “Is the system working properly?” “How do I protect my assets?” Asset allocation is a totally different thing from asset protection. They do go hand in hand somewhat, but … Do I feel secure about where I have my money? Do I know about how much my account is insured for? I think these are valid questions that your members need to ask. They’re not easy for the brokers who receive them to answer.
Somebody calls one of our brokers, or anybody, and says, “Listen, what’s my insurance protection?” I’ve heard these questions. They’re not the number one questions, but they’re not infrequent when I go talk to investor audiences all over the country. I don’t think it’s just the wealthy; I think it’s investors at all levels. “What was the flash crash?” “What was MF Global?” “What was Bernie Madoff?” “What was high-frequency trading?” That’s what I’m talking about.
CR: And just having a group of asset classes by themselves that is diversified is going to help out with protection?
DD: That’s right, that’s one partial form of protection of a portfolio’s value. How easy is it to withdraw money? How does that work? Are you comfortable with the technology and the systems? People cannot evaluate this; we’re not experts. I can’t evaluate it.
I think part of protection, believe it or not, is paying attention to these things, and going to meet the office manager of your broker’s or adviser’s office. My father-in-law used to complain to me about his broker all the time, and I asked “Have you ever met the manager of the office?” (The office is here in New York, on Sixth Avenue. It’s a famous firm, a very big firm.) And my father-in-law said, “No, I’ve never met the manager.” He’s complaining about the broker. I say, “You know what? Go in there. You don’t have to register a complaint, but just ask to meet the manager, shake hands for five minutes. Let me tell you, the service will improve if the broker in the office knows that you know the manager!” That’s part of it, too.
CR: How much do you think that the fears some investors have come from just not fully understanding the risks of what they’re investing in?
DD: You know, Buffett says, “Keep it simple.” Mark Twain says, “Keep it simple.” I think if you don’t understand complex structures and terminology, if you can’t find the price of it, you want to have either no or at least very low amounts of such kinds of assets. I think understanding the basic purpose or function is important. You know, there have been various bonds that were backed by certain structures that were complicated and really not for the individual investor. Leave that to the institutional investors, who have full-time employees whose job it is to parse these things and understand these things. That’s been, I think, a part of asset protection.
CR: Are there certain asset classes you think individual investors should look at and particularly consider holding within their portfolios?
DD: I think everybody needs to think about having some inflation protection. These inflation-linked bonds are rich now, they’re not cheap. They currently give you the consumer price inflation index (, minus a certain percentage. They used to give you the CPI plus 2%, 3%, 4%. Now they give you the CPI minus anywhere from 0.5% up to 1%, depending on the maturity.
I think individuals also need to think about having some international diversification. That might be foreign stocks in the form of ADRs; it might be through U.S. mutual funds or other investment vehicles where the price is determined by a basket of European or Asian or emerging market stocks. Exposure to global economic advancement and exposure to inflation protection are important.
And if you’re wrong, you need some exposure to deflation protection, and that would be high-quality government bonds and the highest-quality corporate or municipal bonds.
I think people need companies with great balance sheets and a history of paying dividends, and perhaps even also of repurchasing their stock. As you know, the longer you get into investing—10, 20, 30, 40 years—dividends become even more important as your time horizon lengthens, and it’s important to consider reinvesting those dividends back into equities. That’s where compounding benefits come in to play. You’ve got to make sure that they’re Buffett-style companies that have a long-term staying power and a “moat,” which is what he calls a defensible, competitive position.
And technology can change on you. People who had certain popular tech stocks four or five years ago, or before that, they were sitting on top of the world. But as Buffett has said, things in technology can change so rapidly that when you’re going to buy these global gorillas you need great global consumer products or health care companies, firms that have global presence and exposure to global growth, a defensible moat, impregnable balance sheets, good dividends, and a willingness to pay and increase dividends. Those are some of the things that we would want to see in people’s portfolios.
You should also have some cash reserves. Don’t overdo it, with any of these things. Balance is important.
CR: I’m sure you get this question as well: What about for those who are retired and looking to generate portfolio income?
DD: Retirees may want to consider master limited partnerships. These are sort of yield-oriented, pass-through-type companies that pay out generous returns. Congress lets them do that as part of a desire to increase the energy infrastructure, the pipelines, the oil storage facilities, the natural gas domes and caverns.
However, people have to pay attention to whether something has too high a yield. Sometimes this can be an indication that the yield may not be sustainable. There’s a sweet spot, currently between 3%–6%: You want to try to find companies that are buying back stock and have a yield that is between 3% and 6%. If it’s below 3%, the yield is possibly too low. And if it’s above 6%, it could mean that there’s something wrong and the company might have to cut its dividend.
CR: You wrote about strategic and tactical asset allocation. Could you elaborate?
DD: Well, strategic is the long-term asset allocation that best fits an individual’s risk profile. This includes their risk tolerance, tax situation, time horizon, where they are relative to retirement, what their personality is like when they encounter losses. For example, do they panic and sell out? Do they buy more? How do they drive? Some people drive at 45, 50, 60 miles per hour. Others need to drive more slowly. And others can drive, on proper roads and with proper speed limits, at the speed limit. But not everybody drives the same, and not everybody invests the same.
CR: I guess this also goes along with how people perceive their desired return and their required return, correct?
DD: Yes. The strategic and the tactical. The strategic is basically long-term. The tactical is where you feel—based on your own work or input from companies like ours or big asset management or financial planning or investment counseling companies—there are certain things that are undervalued or overvalued. So let’s say the banks have been beaten down. Is it time to consider adding some banks? Selectively, good quality things can get way overpriced. So, government bonds are very high in price, and the yields are rock-bottom low: Is it time, from a tactical point of view, to move out of those with high prices and low yields and into corporate bonds or municipal bonds of high quality that have a little bit higher yield?
So the tactical is where you try to take advantage of overvalued or undervalued situations. That’s really where the difference between strategic and tactical lies.
CR: What about rebalancing? Any suggestions on when an investor should consider rebalancing or how frequently they should do it?
DD: There’s a big debate over that. Some say by price; some say after a 10% or 20% move, you want to look at rebalancing; some say 50%. There are different parameters and triggers. Others say once a year. I don’t think it should be too frequently, because you generate way too much expense as far as commissions and transactions. But I think from a time standpoint, you want to at least be looking at your allocation like every six months and maybe consider rebalancing. For most people, there’s no set answer. Most people should probably look at their portfolios once or twice a year and ask, “Is this stuff out of whack?” You know, emerging market stocks fell 50% in 2008. Okay, they’re not going out of business. These countries have good fundamental dynamics. There’s good growth. Their finances are in reasonably good shape right now. So maybe add a little bit. Government bonds in 2008: 10-year Treasuries went up 20%. Maybe we need to rebalance a little bit—because the next year, they went down 10%, as you know.
In the chart of asset class performance for the last 10 years (Figure 1), you can see what I’m talking about in terms of the shift that took place in 2008–2009, and that’s the rebalancing.
And rebalancing regularly is like everything else. You know, we all say we want to keep good diets and eat properly. We say we’ll exercise a certain number of times per week and eat so many helpings of fruit and vegetables.
People have to realize that it’s very hard to stick to many of these regimens. You’ve got to evaluate your own ability to keep to a plan. In fitness terms, if you can’t, then you would probably want to have a trainer. In financial terms, the trainer is maybe somebody who talks to you from time to time. It could be a broker, it could be a financial planner, it could be anybody whose judgment you trust and who you think is looking out for you.
That’s part of rebalancing, because many people have found that if they’ve got a trainer, they go to the gym and are more disciplined. And I think that’s what you’re talking about as far as the rebalancing discipline. We all say we’re going to do it, but in 2008, when stocks dropped 37% in the U.S. and 53% in emerging markets, it’s so easy to look back and say, “Oh yes, we should have taken some money and put it into this asset class that dropped.” But at the time, it seemed like the wheels were coming off the car. So part of the discipline of the trainer is to force you to consider—to consider—doing the rebalancing. Rebalancing by price and rebalancing by time.
CR: Finally, could you give some data points that you think individual investors should pay attention to when looking at the markets and looking at performance?
DD: You want things you can keep track of and that you can hear about. Obviously, the employment numbers are important, and so is watching the Federal Reserve. Corporate profits are important. Management’s quarterly earnings calls should be monitored, to the degree that many of your members can once in a while listen in on them. If they cannot do that, they can read the papers to find out what corporate managers are saying about the outlook for corporate profits. You’re going to get interest rates from watching the Fed. And you’re going to get corporate profits from listening to and watching the CEOs of these companies. These are, to me, some of the key things.
But there are many other things, as well. There’s the consumer price index. Fiscal policy. Taxes—taxes on corporations, taxes on dividend income, taxes on interest income. Those are also some of the things to watch. Policy has become more important as a thing to monitor. These would be some of the other key indicators.
Investor sentiment is something to watch—the AAII Sentiment Survey. This is not to scratch your back, but the AAII survey is something I watch every week. The long-term average is 39% bulls, 30% bears. So when it gets up to 50% bears or higher, then maybe it’s time to put some money into the market. And when you get 50% or higher on the bulls, maybe it’s time to consider scaling back a little bit. I think the AAII Sentiment Survey would be one of those key things to watch, along with profits, the Fed and interest rates, fiscal policy and tax policy. The AAII survey tends to be important at major turning points: You don’t want it to cause you to flip back and forth nonstop.