Passive Asset Allocations Fall Short 

In 1997, many financial planners thought that they had discovered the holy grail of investing in the most comprehensive, objective study ever done of historical returns in the U.S. capital market -- Stocks, Bonds, Bills and Inflation: Historical Returns (1925-1996). The authors, Roger Ibbotson and Rex Sinquefeld, analyzed the indicated asset classes, their total returns and their volatility over extended time periods. 

Their conclusion was that small stocks can be expected to return an average 12.5% annually, while large cap stocks, represented by the Dow Jones Industrial Average, would average 10.0%. Bonds were pegged at an average annual return of 5.2% while treasury bills could be expected to average 3.7% annually.

The Securities and Exchange Commission has long required money managers and investment advisors to warn clients that past performance is no guarantee of future returns. But that didn't stop the planning industry from trotting out historical returns as a basis for designing passive allocation investment portfolios. Some planners implied that all investors needed to do was to establish their required rate of return and risk tolerance based on existing savings and intended future savings, have a passive asset allocation prescribed, and then build a portfolio of mutual funds to meet that allocation. 

The idea that large cap stocks gain 10% per year on the average also formed the basis of arguments against trying to "time" the market, or actively manage portfolios.

But times have changed. Roger Ibbotson, head of Ibbotson Associates and co-author of the Ibbotson-Sinquefeld study that ingrained the 10% concept, now says the next quarter century will not live up to the past 75 years. Why? Conditions are different, says Ibbotson. 

Fidelity Investments recently lowered to 7 percent its annual return target for its in-house pension plan. The Vanguard Group's Plain Talk About Realistic Expectations For Stock Market Returns has been removed from the fund family's web site. Likewise data on historical returns (up to 50 years) from T. Rowe Price are gone from that firm's web site.

We don't know what returns will be for the next year, or the next twenty years. Nor do we know which market sectors will prove the most profitable. In fact, the most accurate prediction of market behavior may well be simply that stocks will go up and go down. What we do know is that fluctuations create opportunities for profit if investors are willing to take an active approach. 

Financial markets tend to establish trends, some short, some longer. The active manager strives to be positioned on the right side of the trend. To quote Will Rogers, "...if it don't go up, don't buy it." Because we are not limiting ourselves to a fixed allocation, investment positions can be flexible to take advantage of different sectors. As a result, returns are not limited to those achieved by the major market indices. 

Active management doesn't need to be 100% accurate because many short-term moves are continually taking place in the financial markets, providing opportunities to recapture losses from trades that don't work out as hoped. To achieve Ibbotson's once forecast average annual return of 10% annually, an active management strategy would need to realize 0.8% a month and let it compound.