Decision Making Under Conditions of Uncertainty

By training and by inclination, financial planners typically construct portfolios under the illusion of certainty.  The most popular investment strategy for professional investors, strategic asset allocation ("SAA"), assumes that financial markets are efficient and that risk premiums, the amount that stocks outperform inflation, will be positive and stable over time.  The most cherished assumption for financial planners and investment advisors is that stocks will outperform inflation, cash, and bonds over time with certainty.  Therefore, in order to add to expected portfolio returns, a planner need only add to the equity allocation of a portfolio. 

However, everything we know about managing risk in SAA portfolio construction changes with the realization that risk premiums are not stable and positive over time.  In fact, the data shows that markets are surprisingly inefficient and returns can be much lower than average expected returns for periods as long as twenty years.  Specifically, the data shows that when buying the "market" as represented by the S&P 500 index, either at peak profits or at peak price/earnings (P/E) multiples, the expected 20-year returns for the S&P 500 Index can be much less than the average expected returns assumed in SAA.

Figure 1 shows the 20-year returns of the S&P 500 Index ranked by decile from lowest returns to highest returns.  The chart shows the range of each decile return and the average return for each decile.  Finally the chart shows the average P/E multiple of the S&P 500 at the beginning of each decile and the end of each decile. 

Clearly the "average" historic expected returns of 11% are not realized by investors who own the "market" for periods of 20-years when they buy the market at high P/E multiples.  The chart illustrates that high return periods occur when the multiple is low at purchase and then expands during the holding period, but the returns are well below the expected average return when multiples are high at purchase and then contract during the period.

The data also seems to suggest that historic "average" returns are not realized over twenty year time periods when buying the market at peak earnings.  Figure 2 shows the 20-year nominal and real returns of the S&P 500 index, excluding dividends, from each period of peak profits over the past sixty years.  Again, the only periods where expected average returns are realized are the 1980's and 1990's when P/E multiples rapidly expanded.  The remaining time periods show 20-year nominal and real returns that are significantly less than expected.

A traditional view of value investing implies that buying stocks at or beneath their intrinsic value minimizes the downside volatility of the investment since, in theory, prices should not fall too far below the asset class's fair or intrinsic value.  Value investing also implies that buying below intrinsic value enhances the opportunity for capital gains as investors bid prices up to fair or intrinsic value.  Clearly, buying stocks at high prices versus their earnings, or when the economy operates at peak earnings, does not constitute good value, and investors can expect higher volatility and lower returns when buying stocks at such high prices.  The converse also applies:  buying stocks at low P/E multiples and below the peak earnings of an economic cycle should minimize portfolio volatility and maximize capital gain opportunities.

Depending on how one analyzes the data, today's market environment is one of either peak profits and fair P/E multiples, or peak profits and high P/E multiples.  In either case, planners should not be certain that average historic returns will be returned by buying and holding stocks for long time periods of up to twenty years.  If this is true, then planners must consider making portfolio construction decisions under conditions of uncertainty.

Who is Responsible for Finding Value?

In the most traditional sense, financial planners who utilize SAA object to the term "value" as used by money managers.  They claim that, when assuming efficient markets and rational pricing, there is never an opportunity to purchase or sell securities at prices that do not represent fair value.  Therefore, "value" is impossible to find.  In actual practice, most financial planners allocate money to money managers whose job is to find value within a specific asset class and style category in the portfolio and thereby deliver superior performance.  Planners invest in either no-load mutual funds or separate accounts where the investment managers are expected to generate performance that is superior to an unmanaged benchmark for each style or asset category.  The best money managers will find value within their investment style, but if the asset class is overvalued, then the manager will only be able to deliver good relative value.  An equity manager might have a -20% return when the stock market as a whole has declined by 25%.  At such times, it may be the planner's role to find value by changing the portfolio construction so that more money is allocated to asset classes that are undervalued.  In fact, planners are uniquely positioned to succeed in such a role because they have the entire global universe of asset classes to work with in their quest to find good value.  If it is true that planners need to take a more active role in finding value during periods of lower returns, then it is fair to question whether planners are prepared for that role, particularly when SAA continues to offer the illusion that such decision making is unnecessary when planning for portfolio returns over twenty year time horizons.

It could be argued that most planners are not, in fact, trained to make asset-allocation decisions under conditions of uncertainty.  Most planners, still clinging to the unrealistic promise of predictable returns offered by SAA, consider "predicting the future" or "market timing" unprofessional and impossible.  Yet making market forecasts is a fact of life for a wide variety of financial professionals, including central bankers, money managers, and executives at any major company.  It is a necessary and expected part of their job description to make forward looking decisions about interest rate policy, or security selection and timing, based on their "best estimate" about the future.  Whether it is the future direction of U.S. economic growth and inflation, or future cash flows and profits of individual companies, it is clear that making decisions in an uncertain world is far from impossible and unprofessional.

While forecasting and the subsequent decision-making that comes with it may be necessary and possible, it certainly is not easy.  Consider the following quote from Bill Gross, the highly respected and successful Managing Director of PIMCO--one of the largest fixed income managers in the world, " ...tricky business this forecasting.  Even when posing as a long-term oracle as Francis Fukuyama did when he wrote his famous The End of History and the Last Man in 1989, the world can zig and zag and stone you intellectually faster than you can say Islamic radicalism.  I shall don sufficient armor and prepare to be stoned."² It is probably true that most planners would prefer to ignore the realities of uncertain risk premiums rather than joining Mr. Gross in donning armor and being stoned.  Aside from the psychological pain that comes from making "wrong" forecasts and asset allocation decisions, there are several other misperceived barriers that planners face when considering a more active style of portfolio construction. 

Taxes:  Active asset allocation often results in the realization of capital gains as securities are sold when they appreciate to their fair value and the sales proceeds are reallocated to undervalued asset classes.  Planners often wrongly think of capital gains taxes as a "drag" on portfolio returns, when in a low-return investment environment the realization of capital gains may be the best way to "lock-in" gains and avoid the losses that come from market declines.  In fact, holding securities in volatile investment environments in order to get long-term capital gains treatment or to defer the realization of gain may be a high-risk strategy.  Table 1 shows that a security with a 20% unrealized gain would only have to decline in value by 3.06% in order to completely eliminate the tax benefits of holding for the long-term gain (assuming a 28% short-term tax rate and a 15% long-term rate) and end out with the same after-tax wealth.  Capital gains taxes are always an important aspect to any wealth appreciation strategy; however, they must be viewed in the context of trying to avoid economic losses in difficult markets.

Client Perception: Implementing an active strategy usually results in an increase in the number of transactions in a portfolio versus buying and holding securities using SAA.  To the extent that several transactions result in losses, and even if they do not, clients may be unhappy with more rather than less portfolio activity.  In addition, clients will often focus on losing trades, even if the trades represent proper risk management and even if the portfolio performance remains well ahead of benchmark.  Yet planners need to consider the client's perception of SAA after years of unexpectedly low returns.  The reality of a prolonged low return environment may be that clients expect a more proactive strategy, and the greater risk is buying and holding.  As with any planning strategy, clients and their advisors need to be educated regarding the purpose of the transactions, within the context of implementing a comprehensive portfolio strategy, to minimize portfolio risk by investing in value. 

Lack of conviction:  Planners may misperceive the amount of conviction required to make an active asset allocation decision in times of uncertainty.  Many planners compare the uncertainty of taking a profit in one asset class and reinvesting the proceeds in another to the apparent certainty of buying and holding for the long-term.  Yet, neither strategy offers certainty.  In fact, in low-return investment environments SAA offers the virtual certainty of underperforming because, by definition, the planner buys and holds low-returning assets (stocks) that only offer increased volatility for no increase in returns.  At a minimum, planners should realize that they are already operating in an environment of uncertainty.  Planners must have a high degree of conviction about the decisions they make, however, they must realize that unless they really can foretell the future, their level of conviction will fall short of certainty.  The markets will typically offer a planner several trades that seem to offer value.  At all times there will be reasonable and persuasive arguments for either side of a trading decision.  Planners must complete those transactions that seem to offer the best possibility of success based on the planner's expertise and experience, while managing to the risk that their assessment of value was incorrect.  If they are unsure of the transaction, planners can simply continue to own their benchmark, or target, portfolio in a strategic way until another opportunity comes along that they do have high conviction in. 

A current example of possible poor value is the relationship between small-cap stocks and the general market.  Figure 3 shows the relative strength of the S&P 600 small-cap index versus the Wilshire 5000 total stock market index.  The regression line shows that small-caps typically return approximately 1.5x the return of the total market.  Yet today's relative strength index shows that, after six years of outperforming large-cap stocks, small-caps are now more than two standard deviations above their average performance.  Planners might consider whether small-cap stocks are now over-valued versus the market as a whole.  If planners conclude that small-caps are overvalued, they might take profits in the small-cap allocation of the portfolio in favor of another asset class, including cash.  Planners contemplating this trade should consider that valuation is traditionally a poor catalyst for short-term market moves, and small-cap stocks could continue to outperform for several more years before they regress to their average performance versus the market.  Alternatively, planners might consider that taking profits today in volatile small-cap stocks may add significant value to a client's portfolio return in declining markets.

Figure 3

Special Considerations for Affluent Investors:  When explaining a buy and hold portfolio strategy to clients, perhaps the most important issue for them to understand is that the strategy demands that the client accept short-term portfolio volatility as a trade-off for the certainty of long-term returns.  In fact, SAA strategy may trade-off high, short-term volatilityfor uncertain,long-term returns.  In contrast, actively managed portfolios, where financial planners actively participate in finding value, trade the uncertainty of long-term returns for the higher probability of minimizing short-term portfolio volatility.  Monte Carlo simulators, which show the probability of success for different portfolio constructions based on thousands of possible future portfolio returns, clearly illustrate for planners and their clients that affluent investors need not be as concerned about missing returns from a financial planning perspective.  They can often meet their financial goals with very conservative portfolio constructions due to the size of their portfolio relative to their spending requirements.  Therefore, minimizing short-term volatility actually becomes the more important consideration when dealing with high net-worth clients.  Instead of planners "selling" clients on the necessity of accepting 100% of the market's volatility based on the assumption that all markets are efficiently priced and market timing is impossible, they can instead implement a strategy that offers some potential for maximizing returns, or minimizing losses, in volatile markets.  The consequences of being "wrong" and missing a market rally are significantly minimized, as long as the client understands the planner's rationale for making decisions under conditions of uncertainty.

Summary:  This paper posits that Strategic Asset Allocation ("SAA") may not deliver expected returns when equities are purchased at either high P/E multiples, peak profit cycles, or both.  Financial planners who utilize SAA do not offer the certainty of returns that seem to be promised when evaluating long-term average returns where stocks are always presumed to outperform inflation, cash, and bonds over twenty-year time periods. 

Planners may wish to consider more active styles of management where they participate in finding value in portfolio construction.  Similar to central bankers and money managers, planners will make these decisions under conditions of uncertainty.  Taxes, client perceptions, and lack of conviction are all barriers to good decision making under uncertainty.  Planners should understand that each of these issues becomes easier to deal with in the context of recognizing that SAA decisions also involve a high degree of uncertainty about long-term returns.  Finally, affluent clients have a special relationship to risk and reward where avoiding risk is arguably the higher priority.  Active management strategies offer a higher probability of avoiding short-term market declines because planners are allowed to actively find the best values in the universe of possible investable asset classes.