Asset Allocation and Bad Habits
This article documents the “bad habits” of investors in asset allocation practices. Whereas financial markets exhibit momentum over multi-month horizons but more reversion to the mean over multi-year horizons, many investors act like momentum investors even at these longer horizons. Both these patterns are well known anecdotally but have not been well documented statistically, especially together. This article therefore addresses two empirical questions. First, How do funds reallocate based on past returns? The authors provide direct evidence using the CEM Benchmarking data on pension fund target allocations over a 22- year period. Second, What are momentum/reversal patterns in financial markets returns? Evidence is provided using more than a century of data. Merging the findings from the two data sets provides evidence consistent with the premise that investors chase returns over multi-year horizons, which is likely to hurt their long-run performance. However, the statistical evidence on pro-cyclical multi-year asset allocations and multi-year mean reversion patterns in asset-class returns is on the borderline of statistical significance.
International Diversification Works (in the Long Run)
Investors and financial economists have long debated the benefits of global equity market diversification. Fans argue that diversifying globally reduces portfolio risk without harming long-term return. Some critics counter with the observation that because markets get more correlated during downturns, most of the diversification occurs on the upside when you do not need it, and vanishes on the downside when you do. Certainly, recent events give support to the critics as all markets have suffered. We argue that this obser- vation, while true, misses the big picture. International diversification might not protect you from terrible days, months, or even years, but over longer horizons (which should be more important to investors) where underlying economic growth matters more to returns than short-lived panics or global coordinated events, it protects you quite well.
All photography by Jared Chambers