“The conventional wisdom is often wrong.” Those were the words of Steven Levitt and Stephen Dubner in their blockbuster hit, Freakonomics, which, by the way, if you haven’t read it is well worth the time and money. This could be no truer than in the financial services realm and, specifically, the sales of investment products and services. Indeed, the entire premise that an investment’s asset class—its label as large cap stock, small cap stock, international stock, short- or long-term bond—as the PRIMARY determinant of its risk, must be questioned.
Here’s how Jim Stovall and I put it in The Financial Crossroads in the chapter entitled, “Portfolio Management: All Things Considered Equal”:
Have you ever heard anyone say, “All things being considered equal…” and then follow it up with a statement? They may just be an economist. It’s like saying, “If everything happens the way I expect it to, I’ll be home on time for dinner.” It’s really an out. In economics, enormous models are created with assumptions too numerous to count, and the aforementioned phrase gives the economist an out when circumstances beyond his or her control change. This phrase is especially important in the management of investment portfolios.
All things being considered equal, stocks are more risky than bonds. Growth companies, more risky than value companies. Small companies, more risky than large companies. International countries and companies, more risky than the United States and companies domiciled here. In investing circles, each of these categories is called an asset class. If all things were equal, the above presumptions would hold true. But, especially in the world of investments, all things are never equal! They’re in a constant state of flux, and as Mark Twain told us, “History doesn’t repeat itself, but it does rhyme.”
Departing momentarily from theory into reality, consider the notion that instead of risk being determined by asset class, risk is determined by the price of that asset. The risk of a particular asset is not correlated with its label, but instead, its price tag.
You see, we’re not suggesting that the asset class is irrelevant, but it frightens us that the financial industry seems to have built its foundation for investing on the widely accepted “science” that an investment’s risk is determined by its label instead of its price tag. This concept is theoretically known as Modern Portfolio Theory or the Efficient Market Hypothesis, but has become broadly known and presented to consumers as Asset Allocation. You’d probably know it better from the pretty pie chart that most often is pulled out to describe it. (All you need to do is “rebalance” between the asset classes when the pie chart gets out of whack and VOILA—a lifetime of investing made simple!)
So if you were one who had wondered if your pie chart wasn’t cutting it, or if you were relying too heavily on market logic that seemed all too illogical, we’d suggest that your common sense might actually trump the behemoth financial institution!