Stop Blaming Efficient Market Theory For The Crisis. While we're at it, stop blaming asset allocation. The efficient markets theory asserts that only investors with inside information can consistently beat the collective financial markets (yes, trading on inside information is illegal). Therefore, passive investing is the way to go. The writer comments that much of the market activity of the last 5 or 6 years was driven by investors who, in fact, believed they could beat the markets and thus were, arguably, not adherents of the EMT. I've long believed that markets tended to be rational over the longer-term (more than 5 years) but that markets were driven by behavior over the short-term. There is a tremendous amount of noise in shorter-term markets as well as a constant internal battle among investors as to whether the guy on the opposite side of the trade knows something I don't. This emotional reaction can cause investors to trade in non-rational patterns and disrupt the EMT.
There is another piece out over the last several days by Brad Setzer that notes a white paper which discusses the role of Emerging Market central banks. Essentially, these banks placed significant assets in U.S. Treasuries, which helped drive down rates. That resulted in investors stretching for higher returns and helped to create the 03-07 bubble. This is another aspect of the behavioral issues - the desire (and the need) to outperform.
Asset allocation has also been beaten up as a "failure" because asset allocation didn't prevent investors from losing money in the last half of 2008 or earlier this year. However, that isn't the point of asset allocation and thus is a poor argument for defining its failure. The intent of asset allocation is to reduce the overall volatility of a portfolio and, thus, minimize the deleterious effects of poor performance. The key is "minimize" not eliminate. Long-only strategies (no shorting of securities) can't fully hedge downturns. If you own a security that goes down in price, you can either sell it and suffer a cash loss or hold it and suffer a paper loss. You have a loss either way. In 2008, you would have had to move entirely to cash to avoid a loss or been fortunate enough to hold the 3 or 4 equities that didn't decline.
Bottom line is that neither the EMT nor asset allocation are "failures". Both have flaws which were laid bare in 2008. What should be done now is to use this crisis as an opportunity to re-examine your own approach to portfolio management. I have argued before that investors, to the extent possible, should focus more on absolute return rather than relative return (to any index or peer). This approach incorporates asset allocation and can incorporate EMT but removes the long-only constraint by necessity. I'll write more on this in future posts.
There is another piece out over the last several days by Brad Setzer that notes a white paper which discusses the role of Emerging Market central banks. Essentially, these banks placed significant assets in U.S. Treasuries, which helped drive down rates. That resulted in investors stretching for higher returns and helped to create the 03-07 bubble. This is another aspect of the behavioral issues - the desire (and the need) to outperform.
Asset allocation has also been beaten up as a "failure" because asset allocation didn't prevent investors from losing money in the last half of 2008 or earlier this year. However, that isn't the point of asset allocation and thus is a poor argument for defining its failure. The intent of asset allocation is to reduce the overall volatility of a portfolio and, thus, minimize the deleterious effects of poor performance. The key is "minimize" not eliminate. Long-only strategies (no shorting of securities) can't fully hedge downturns. If you own a security that goes down in price, you can either sell it and suffer a cash loss or hold it and suffer a paper loss. You have a loss either way. In 2008, you would have had to move entirely to cash to avoid a loss or been fortunate enough to hold the 3 or 4 equities that didn't decline.
Bottom line is that neither the EMT nor asset allocation are "failures". Both have flaws which were laid bare in 2008. What should be done now is to use this crisis as an opportunity to re-examine your own approach to portfolio management. I have argued before that investors, to the extent possible, should focus more on absolute return rather than relative return (to any index or peer). This approach incorporates asset allocation and can incorporate EMT but removes the long-only constraint by necessity. I'll write more on this in future posts.
