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April 1, 2003

Asset Allocation Is Dead

By Kathryn M.Welling

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Peter L. Bernstein. Nothing further is really needed by way of introduction. But let me say this: The well-known economist and portfolio management guru, publisher of the always-erudite semi-monthly journal, Economics & Portfolio Strategy, and author of numerous books on the interplay between the capital markets and the real economy, clearly loves to toss bombs.

Strictly the verbal sort, but bombs nonetheless. It's part and parcel of his talent for making people-even investment pros-think. He set so many of them to that unaccustomed labor-over SuperBowl weekend, nonetheless-with a speech to foundation types that I was getting calls about what he said well before half-time. Provocative isn't the half of it. Forget investing "for the long haul," bond and stock returns from here are bound to disappoint. Real men [and women, not to mention institutional investors], who want real returns, will have to be very creative. -KMW

You created quite a buzz among institutional types with that speech you delivered at the end of January. I hear you told them that all the old investment rules no longer apply. But is that really news, considering the graphic demonstration we've had that things are different in the last three years?

Well, what we've had is a graphic demonstration of boom and bust. That's a familiar pattern. What's expected is that after the bust, you pick up the pieces and go forward. That this is different, people are reluctant to recognize. A real difference pulls them away from traditional ways of managing their affairs. I mean, people think, "I won't get caught in the next bubble, I'll get out sooner." But that's different from saying, "The basic investment structure that I've been using, which served me pretty well, is no longer appropriate." They have to be persuaded, because they think the long run tells them things that would justify continuing doing what they have been doing.

You're implying it doesn't?

I am suggesting that we have to begin by focusing on the meaning of the long run-think about it differently in the post-bubble world. That means that our approach to investing's fundamental problem, asset allocation, has to change. The thrust of my argument is that we are going to have to learn to live without the crutch of things like policy portfolios-because the conditions that justified their existence for so long have been shattered.

"Policy portfolios?" What does that jargon mean?

Essentially, they are a flexible crutch on which institutional investors lean to indicate they have an orderly portfolio built on some kind of underlying structure. In other words, I'm talking about the broad policy statements investment committees typically make setting out their views on the relative long-term attractiveness and risk in available asset classes. And long-term is the operative word there. But these days, they are quite often arrived at through highly technical and sophisticated quantitative optimization processes involving long-term expected returns, volatilities and covariances, aimed at minimizing risk relative to return (or maximizing return relative to risk).

You're saying they're not worth the effort?