A Matter of Balance


Date: 05-May-98 - 7:44 AM
Subject: A Matter of Balance
From: Bylo Selhi

Portfolio theory says that one should set up a portfolio according to an asset allocation plan and then periodically rebalance the assets in order to keep one's allocation in line with the plan.

Suppose a decade or so ago Jane Investor created a portfolio that was allocated 40% fixed income and 60% equities. She allocated the equity part of her portfolio in only the largest (and presumably most stable economies) roughly in proportion to their market capitalisation, say 50% in North America, 25% in Europe and 25% in Japan.

Now we all know what happened to the Japanese markets 9 years ago. Nevertheless following theory, Jane continued to rebalance her portfolio in order to achieve the original allocations. She channelled fund distributions and even some new investment money into Japan.

Jane's been doing this for nearly 10 years. The Japanese markets remain depressed and no end is in sight. Meanwhile she's partly missed out on some very juicy gains in NA and Europe.

How long should Jane continue to keep her faith in portfolio theory before she can expect to be rewarded? Another year, 5 years, 10 years? Can she ever hope to catch up with investors who kept all of their assets in NA?

What advice would you offer to Jane?

Date: 05-May-98 - 9:49 AM
Subject: RE: A Matter of Balance
From: Bemused Lurker

Doesn't seem unreasonable according to the "mighty tomes" I've read.

What I mean is that several articles on diversification indicate that no matter how careful you are, out of 10 investments you can expect 1 to be wiped out, 1 to do great, and the remainder to straddle expectations (reasonable). Not sure of the basis of this thought, just that it's in several books.

So out of 100% invested, jane shows a loss on 15% of her portfolio, but it's not a 100% loss. Therefore, she is down, but not out on that portion of the investment.

At the same time, her investment in North America will most likely have more than offset her loss in Japan. (this is highly dependant on which sectors she invested in and how aggresive she is - compare the difference in returns between Ford, GM, Bombardier, Bre-ex, etc).

In the mean time, depending on what type of fixed income product she got 10 years ago, (25 year Government of Canada bonds for instance) she could be sitting very pretty with a fixed income return well above the long term return for equities. (Sort of makes you wish - at this point).

Rebalancing, from the other markets into Japan would occur, but what is also missed is that there would have been a reblancing into Europe over the for the first several years, and now she would be reaping the benefits. The strategy can work, if you can be disciplined and stay with it.

All in all, not a bad mix, too aggresive in Japan for me, but each to their own.


Date: 05-May-98 - 11:48 AM
Subject: RE: A Matter of Balance
From: thbox

Deliberately ignoring the thrust of your question, I want to point our that Warren Buffet is on record as saying: "Modern portfolio theory is garbage". But what does he know? :-)

Date: 05-May-98 - 11:52 AM
Subject: RE: A Matter of Balance
From: George

Gosh Jane, perhaps I can help unfuddle your befuddlement.

Seriously - this thread is close to my own interests.

Fixed Income. Jane, why did you put 40% of your portfolio in fixed income ten years ago - if you knew you would not be needing the money for 10 years? I would have made this number 0% for myself and no more than 10% max for someone who needs to toe the conventional line a bit. I have it on good authority, from Peter Lynch I believe, that this would have been a wiser course.

Equities. I'm assuming you still have a ten year horizen.

Are you still at 25% in Japan today? Why? Even if your reasoning was that you want to reflect its market capitalisation, today it should not be no more than 10%. [Before the Japanese market drop it might have been 25%, but today I believe it is about 11%.] In other words if you want to maintain world market representation use current ratios, not your original ratios.

I would advise against putting serious investment money into a foreign market unless you yourself are familiar with that market and feel comfortable with it. You and I have grown up in North America and know how the system works here, the culture, the press, the accountability and everything else. Thus we have some basis in knowing what to expect from its financial dealings. Japan and Asia are a totally different world - different cultures, different defference to authority, you name it. The way governments and large businesses work with each other is different than in NA. I don't believe you have the same degree of openess as in NA. Thus I would not feel comfortable with having more than 10% of my assets in the Asian economy, Japan included. I would make it either 0% or 10%.

Europe is again different. Because of the forthcoming Union and Eurodollar- Europe may well have a sustained economic spurt and I would leave it at 25%.

The North Americam portion I would split 50-50 between Canada and the US.

Any time, any time. Remember that you are only getting what you paid for.

Date: 05-May-98 - 12:19 PM
Subject: RE: A Matter of Balance
From: PK

Hi Bylo -

Three quick points (I'm hunting and pecking left handed due to a weekend injury).

1) Any ex-post analysis will provide examples of opportunities lost. Taken to extreme, why didn't Jane invest in the one stock that rose the most during the 90s?

2) Since MPT provides a middle ground for both return and risk, perhaps the perspective of a Japanese investor is useful. This investor loves the fact that MPT diversified them out of Japan.

3) 25% is quite a bit too high. Maybe in 1989-90 if you were basing an allocation on market cap, but I think a GDP allocation is mor prudent. Afterall, in the long run stocks are tied to economies not market caps.

Date: 05-May-98 - 6:39 PM
Subject: RE: A Matter of Balance
From: Bylo

To all, thanks for your reasoned responses. A clarification: Jane's primary concern is with the Japanese part of her portfolio, i.e. how long does she continue to "throw (invest) good money after bad"?

BL, the "mighty tomes" tell us to redeploy profits from the winning assets into buying more of the losers, um "selhi to bylo" so to speak. The question is how long does one do this in the blind faith that eventually the losers start to recover and hopefully make up for the drag they've been to the portfolio. MPTers take this as a matter of faith. Japan seems to be a good test of that faith, no?


George, The 40% fixed is what the "average" balanced fund holds. Jane's concern is not with bonds. They've returned over 10% a year during the last decade. Not too shabby for something so boring.

Where did you get the market cap figures?

PK, hope your injury is not too serious.

1) Because she wanted to have a balanced and diversified portfolio. Ten years ago the Japanese economy was the envy of the world; Americans and Europeans were running scared. Putting 10% (0.4 x 0.25) of one's portfolio in Japan was not considered an "act of aggression."

2) Good point.

3) Also good point. Where would one get current GDP info by country or region in say US$?

Date: 05-May-98 - 6:50 PM
Subject: RE: A Matter of Balance
From: PK

To Bylo-

Just a broken collar bone, thanx for asking. I'm now a 3 time loser when it comes to that injury.

Two quick things -- You probably know that if you compared EAFE vs SP500 returns since 1975 or so they are almost equal. MPT is best viewed long term and even then there are no guarantees.

Re current GDPs, I've seen them somewhere on the web recently, but damned if I can remember (should have bookmarked). I'll see if I can find the site despite being mildly (but pleasently) buzzed on Tylenol 3s.

Date: 05-May-98 - 7:59 PM
Subject: RE: A Matter of Balance
From: PK

To Bylo-

The following site was found via Paul Krugman's webpage:

Labour Stats

One of the reports at this site gives Real GDP per CAPITA for 14 countries in US $ terms. Lots of other good stats at this site as well (eg. historical inflation rates).

Find yourself some population stats and you are away to the races. Note that the stats go to 1996, but it isn't hard to calculate (or estimate) current GDPs.

Date: 05-May-98 - 8:01 PM
Subject: RE: A Matter of Balance
From: Greg B

Bylo...you may want to try http://www.yardeni.com/sitemap.html as well.


Date: 05-May-98 - 9:44 PM
Subject: RE: A Matter of Balance
From: George

I’m with Buffett, Lynch, Thbox –[in that order I think] – in my skepticism of modern portfolio theory. [Does MPT stand for Modern Portfolio Theory?] Anything that has both words, “modern” and “theory”, in it must be intellectually subversive. Seriously, I’m always looking for good old fashion “common sense” [a phrase I liked before Harris desecrated it]. Thus I question the notion of “periodic rebalance on general principles”. This can be a costly make-work enterprise. Buffet [again using common sense] reminds us that unrealized capital gains is one of the greatest levers of all financial time. Unrealized capital gains are an interest-free loan with no call date. Rebalance at your own peril.

Come to think of it, I have never owned any Balanced Fund.

You ask about the market cap figures. Sorry I have no web reference. They come from the G&M, April 30/98 issue, in ROB and Alexandra Eadie’s “On the grid” pie chart. The numbers represent the December 31, 1997, weight in the Morgan Stanley Capital International’s All Country World Index .

89% of the world’s capitalization is found in the United States, Europe and Japan, with the relative numbers as 47%, 31%, 11%.

The remaining 11% is made up of: - 5% Asia Pacific ex Japan, 3% Latin america, 2% Canada, 1% other.

Date: 05-May-98 - 10:46 PM
Subject: RE: A Matter of Balance
From: PK

Hi George-

This obscure Swedish organization did not think MPT was intellectually subversive:

Swedish Organization

Date: 05-May-98 - 11:11 PM
Subject: RE: A Matter of Balance
From: oldman2

Interesting comments on asset allocation. I'm a firm believer in using it but wonder why "Jane's" is so rigid. Asset allocation should evolve over time to take into account both personal and market changes.

If I remember correctly, for a short time the Tokyo exchange was the largest in the world - then the bubble burst. At that time she should have re-examined her asset allocation and changed it to underweight Japan due to the uncertainty, etc., that were and are still prevalent in that market.

Jane should have practiced Dynamic Asset Allocation.

Date: 05-May-98 - 11:49 PM
Subject: RE: A Matter of Balance
From: George

Hi PK: - Thanks for the link, I will have a look at it. And I was only half-serious about the subversive stuff [my words sometimes carry me away]. But I must confess to not being a great fan of economic theory in general. I tend to think of economics as a “dismal science” but unfortunately it is all we have so I should not be too harsh. I’m revealing my prejudices and I do hope you are not an economist.

I’m very sorry to hear about the broken collar bone and I hope you will recover quickly. --- You aren’t a rock-climbing economist by any chance?

Date: 06-May-98 - 12:05 AM
Subject: RE: A Matter of Balance
From: PK

To George-

No, not a rock-climbing economist, just a frisbee-throwing MBA.

Date: 06-May-98 - 1:35 AM
Subject: RE: A Matter of Balance
From: bwg

Hi Bylo, It has been a while. Anyway my 2 cents worth. I am a believer in MPT but I am using it a bit differently than Jane's' rigid/specific structure. I have 85% of my portfolio in broad based mutual funds, i.e. a diversified Canadian equity fund (for example Ivy Canadian), broad based foreign equity (Templeton Int. or Fidelity Int.), global bonds (Guardian For. Inc.), Can. fixed income (Altamira Income & BPI Div. Inc.). This portion of the portfolio has been set up to reflect my risk tolerance and is rebalanced when the balance is out by more than an amount that I am comfortable with (depends on the market - during the Asian crisis my rebalance target shrank rather sharply). The 15% of the portfolio that is not core I will trade more actively and it is within this portion that I will get into country specific and sector specific funds. It is also from within this portion of the portfolio that I will overweight classes or sub classes. This structure gives me the ability to maintain a fairly flexible portfolio, one that can move into or out of more narrowly focused funds (such as Japan or Europe) as I see fit. If you are going to try to maintain a fixed weight portfolio that includes every major market on an individual bases then you will 1) have a portfolio that has a large number of funds in it (you specifically imply this with your country specific selections in Jane's portfolio), 2) you will be forced to maintain positions in markets or classes that are clearly out of favor for extended periods (Japan, resource, gold, Asia, and possibly bonds going forward from here). This is specifically Jane's problem. Thus in my opinion the correct course of action for Jane is either to modify her approach to something akin to the one I have outlined above, or to diversify using only very broadly based primary class funds. I hope this helps, All the best, BWG

Date: 06-May-98 - 8:34 AM
Subject: RE: A Matter of Balance
From: Zippo

When North America tanks, we will once again be impressed by Asia's (or bonds') performance. Us MPTers have our asses covered. NOT diversifying is the risky and scary approach. My risk tolerance doesn't allow me to move out of Asia and more fully into North America.

I see far too much short term thinking amongst some of the comments here. When the inevitable happens a lot of people will either be crying in their beer, or rushing for the door. 'Why didn't I see this coming, why didn't I jump out of this and into that?' I don't have to jump anywhere, I am already there, and will be until they try to convert the last asian exchange into a time-share condo.

Will it happen? Yes.

When? Who knows. Do you?

Date: 06-May-98 - 8:45 AM
Subject: RE: A Matter of Balance
From: thbox


What exactly is "dynamic asset allocation", and how is it different from "asset allocation" and "strategic asset allocation" and "tactical asset allocation" and all the other specialized asset allocations I can choose from?

Or maybe, just maybe, the whole notion is a marketer's dream, designed primarily to bring more assets under administration os fees can be charged? And all the fancy names are merely thin attempts at product differentiation?

Date: 06-May-98 - 9:42 AM
Subject: RE: A Matter of Balance
From: Bemused Lurker

Further comment:

I think I begin to see the problem we are dealing with here.

Jane's original portfolio choices were made up of one market at its peak (Japan) and several others that have since appreciated greatly. The problem is that at any point that one enters into the investment market, the different countries and assets will perform differently in the future. (sorry if that sounds confusing, I don't have the gift of eloquence, just trying to make a point).

What I mean is that if Jane had entered the market 5 years later, she would have been buying Japan at a low, and US at a high, with fixed income returns also lower. At any point one enters, there is always this wonderful game of hindsite to be played.

As far as rebalancing goes, most rebalancing can occur by reinvesting distributions and income appropriately to make up the balance. I for one don't feel that a 100% rigid requirement is the best way to go. I prefer ranges based on flexibility of available assets.

I agree with the comment on too much short term viewing, but with the added danger of perfect 20/20 hindsight. How many were in Large Cap US over the last 3 years. Could have, would have made a fortune - but for how long?

BL (also could have shorted Asia big time;Did U?)

Date: 06-May-98 - 10:01 AM
Subject: RE: A Matter of Balance
From: PK

Hi Thbox-

Strategic asset allocation is the mix you choose for the long term with your objectives and risk tolerance taken into consideration. Re the other two terms, here's some definitions from Ibbotson's website.

"Tactical asset allocation (also known as market timing or active asset allocation) is the process of diverging from the strategic asset allocation when an investor's short-term forecasts deviate from the long-term forecasts used to formulate the strategic allocation."

"Dynamic asset allocation refers to strategies that continually adjust a portfolio's allocation in response to changing market conditions. The most popular use of these strategies is portfolio insurance."

IMHO, dynamic strategies have some merit, but basically only when applied by large institutional type investors. The cost of continuosly altering your portfolio makes this approach impractical for small investors. Re tactical asset allocation -- it doesn't work.

Date: 06-May-98 - 11:20 AM
Subject: RE: A Matter of Balance
From: JRL

If possible, I would like your impressions of the following case.

My wife and I are 47 yrs. old and have a combined RRSP portfolio of about $430K, allocated as follows: Fixed Income(MM funds,bonds,cash):13.7% Balanced Mutual Funds:40.4% Equity Mutual Funds:25.7% Equity investments(with guaranteed capital; e.g. index-linked GICs):20.2%

We would like to start using the money for retirement in no more than ten years if it grows sufficiently. We have been riding the equity wave for some time, but I'm beginning to think our total equity exposure is getting a little high (about 68% when factoring in 55% of balanced funds). The foreign content component is close to the max, with a 65/35 split between International and Europe.

Any comments/suggestions on the portfolio allocation?

Another concern I have is the number of funds that we hold. Combined, we hold no less than 17 funds! I don't mind the administration of that many funds, but I'm sure I'm losing out by paying all those fees. I will definitely be consolidating as the DSCs gradually disappear. More importantly, I'm wondering about the perils of over-diversification.

Any comments or advice you may have would be greatly appreciated. Thanks.

Date: 06-May-98 - 1:04 PM
Subject: RE: A Matter of Balance
From: thbox


Wouldn't an intelligent "strategic asset allocation" also be a "dynamic asset allocation". Or do I think of a "strategic" allocation when I'm twenty, and then grab the cash and run when I'm 60?

:-) (he says, tongue firmly in cheek)

Date: 06-May-98 - 1:14 PM
Subject: RE: A Matter of Balance
From: PK

To Thbox - (also tongue in cheek)

I suppose if you consider time in relation to a universe that is billions and billions years old (and getting older by the minute) a strategic rebalancing every 1 - 2 decades is roughly equivalent to continuous adjustments.

Date: 06-May-98 - 8:37 PM
Subject: RE: A Matter of Balance
From: thbox

So PK......

How frequently would "dynamic" asset allocation" have me rebalance my portfolio? (And this question isn't tongue in cheek)


Date: 06-May-98 - 8:52 PM
Subject: RE: A Matter of Balance
From: PK

To thbox -

I have never used dynamic allocation myself, so I am only slightly familar with its use in the context of portfolio insurance. This strategy is essentially a risk mitigation approach and requires very frequent adjustments -- that's why its geared to large, institutional investors. From what I understand (and my understanding of this topic is superficial at best) it has had some success, but you should note that portfolio insurance bombed big time during the crash of 1987. I believe there is a chapter concerning this subject in one of Peter L. Bernstein's books. I'll see if I can dig up a more specific reference for you. Other than that, this is not an area in which I have much substantive knowledge.

Date: 06-May-98 - 9:51 PM
Subject: RE: A Matter of Balance
From: thbox

Thanks PK, I'm well aware of the effect that portfolio insurance had as a proximate cause of the 'crash' of 1987. I would appreciate any info. you can get me on "dynamic" asset allocation.

Date: 06-May-98 - 10:55 PM
Subject: RE: A Matter of Balance
From: Keith

Re: Dynamic Asset Allocation. As with many financial terms, there may be various interpretations. Here's one from the Canadian Securities Course text (1995, p.438): "A dynamic strategy is an active portfolio management technique which adjusts the mix between risk-free assets and risky assets as the markets rise and fall. As the equity markets fall, more and more stocks would be sold and placed into risk-free assets. Similarly, as the equity markets rise, more stocks would be purchased. Theoretically, as stocks show weakness, the investment manager sells them, and as they show strength, the manager buys them..... The dynamic approach is the exact opposite of a constant-weighting asset allocation strategy."

Date: 06-May-98 - 11:07 PM
Subject: RE: A Matter of Balance
From: PK

Hi thbox-

Here's a link to Ibbotson's site and an article that briefly discusses the topic. Since the article is pretty basic, you may be more interested in the endnotes (section 5, I think). There are a couple of references that might provide you with fuller details. I have not read any of these references personally, so I can't attest to their quality.

Asset Allocation Article

Date: 06-May-98 - 11:31 PM
Subject: RE: A Matter of Balance
From: thbox

Thanks for the link,PK

BTW, the "information" from the CSI sure sounds like market timing to me....but then, I'm old and out-of touch, I guess.

(Jes' don't unnerstand this new-fangled investment stuff, derivatives, an' all that ....)


Date: 08-May-98 - 12:27 PM
Subject: RE: A Matter of Balance
From: George


My curiosity prompts this note. Is PK the same as KPA?

I wandered into a library yesterday and came across an article "Active Management That Adds Value: Reality or Illusion?" Is this familiar?

I've tried to be discreet in how much information I'm divulging. :-)

Date: 08-May-98 - 1:58 PM
Subject: RE: A Matter of Balance
From: PK

Hi George-

KPA is definitly not PK.

Date: 08-May-98 - 2:30 PM
Subject: RE: A Matter of Balance
From: jog

I've added the (NMN.UN) Newcastle Management Neutral Hedge Fund which is a unit trust because the management specfically states that the performance of the fund is in no way related to the movement of bonds or stocks on the TSE. If this is true and it performs decently then it will have added an additional appropriate dimension to my portfolio.

Date: 08-May-98 - 8:47 PM
Subject: RE: A Matter of Balance
From: George

A question about asset allocation.

Many of the large US companies are international in nature - or internationally diversified. How does one fold this into asset “allocation”? To illustrate: In buying the Vanguard 500 Index fund, GE is its single largest holding – at about 3.1%.

In the 1997 GE annual report, GE has 19% of its revenue from Europe and 17% of its profits from Europe. And it has 4% of its revenue from the Pacific Basin and 2.5% of its profits from there.

GE is traditionally considered to be a “US investment”.


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