If multiple asset class investing is so wonderful, why isn’t everyone doing it? There are three primary reasons. First, investors lack an awareness of the power of diversification. The typical investor understand that diversification may reduce volatility but suspect that it simultaneously impairs returns. Not diminish them. Investors need to be educated about this dual benefit.
Second, the question of the market timing arises. Investors naturally want to believe that there must be some way to predict which asset class will come in first place. And some money managers suggest that they in fact can make such market timing predictions accurately. Let’s assume that we have a market timer with whom we consult annually for his prediction of the following years best performing asset class among the S&P 500, EAFE, NAREIT, and GSCI. Had he successfully predicted the winning asset class over the past 15 years, from 1983 through 1997, an investor following his recommendations would have earned a compound rate of return of 32.33 percent. If such market timing skill exists, there should be evidence of money managers earning these rates of return. A check of morning star’s database, reveals that there is a universe of nearly 600 mutual funds with at least 15 years of performance history. Included is the full variety of professionally managed domestic and international funds, equity and fixed income funds, as well as various specialty funds. How many of these funds had compound rates of return in excess of 32.33 percent? None! Not one got remotely close.
Maybe we are asking too much proficiency from our market timer. Let’s assume that his prediction for the winning asset class each year never finished first but instead came in second place among the four asset classes. This does not seem like a particularly impressive achievement. Yet it would have generated a 15 year compound annual return of 19.59 percent. Out of nearly 600 funds, only three had better investment performance. This is only one half of one percent of all professionally managed mutual funds. And none of the three funds relied on market timing to deliver their impressive returns.
Perhaps that is still asking too much of the market timer. What if we ask him to simply recognize the long periods of dominance of one asset class over another? For example, our market timer might instruct us to invest our funds in EAFE during the portion of the 15 year period that fell in the 1980s and then switch to the S&P 500 for the 1990s. this strategy would have generated a compound return of 22.81 percent. Again, not one mutual fund manager among 638 funds achieved that rate of return. Apparently, predicting the performance of asset classes is hard to do successfully.
The third reason involves investor psychology. Investors use their domestic market as a frame of reference for evaluating their investment results. For example, a united stated based investor will compare her equity returns to a market index like S&P 500. This frame of reference is not a problem in years when the domestic market underperforms other asset classes, since diversification into better performing markets rewards a multiple asset class investor. When the domestic market comes out on top, however, the investor perceives that diversification has impaired her returns.
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