Lessons learned: asset allocation after the 'great recession'.

• Author: Framson, Joel H.
• Position: Financialplanning

Whether we manage the money ourselves or act as a sounding board, CPAs are often involved with investment decisions for clients--and it's likely that we were profoundly impacted by the gyrations of the capital markets. We know our clients' goals and we understand their fears. And if we're to serve our clients well, we must understand what went wrong to modify our investment approach and advice.

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Looking Backward

The first issue we must address is whether we agree that something went wrong in our understanding of risk and implementation of an effective asset allocation strategy. While, we can't control returns, the control of risk is a key element in designing an appropriate portfolio.

Modern Portfolio Theory (MPT) has been a cornerstone of portfolio building for decades. Magazine space will not permit a detailed analysis of MPT and related calculations, but we can briefly describe the theory and identify alternate approaches based on what we've learned and observed.

Harry M. Markowitz and William F. Sharpe advanced the asset allocation process by creating a multidimensional framework in attempting to create efficient portfolios. Markowitz posited that "optimal" portfolios could be developed that would maximize the return for a given level of risk, or conversely, minimize the risk for a given level of return.

As we know, the formula for optimizing the portfolio required a computer program to assess standard deviation as the measure of risk, correlations between asset classes and expected returns.

However, when these theories were being advanced in the 1950s, computers were much less powerful than today. Markowitz settled on a methodology that was somewhat simplistic, but the best that could be done at the time.

His optimization program focused on measuring risk (standard deviation) as the deviation of an asset's return compared to its long-term average return.

This is a critical concept and a significant limitation due to the limited computer power at the time. The computation considered deviations above an asset's long-term return to be equally significant to those deviations below the average return. In other words, the program looked at a return of 30 percent as being as risky as a return of negative 10 percent if that asset's average return had been 10 percent. In each computation, the deviation was 20 percent--therefore the standard deviation computed to be the same.

Markowitz stated a very important difference--he would have preferred to use an approach that could focus on downside risk. Standard deviation views upside and downside...