Too few asset classes?

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Too few asset classes?

Postby boggler » Mon Jul 01, 2013 11:15 pm

From an article by the head of Wealthfront:

Online brokerage firms aren’t much better. They offer free asset allocation tools, but those tools prioritize simplicity over financial rigor – in effect interpreting da Vinci’s thought in the most shallow fashion.
To keep their work simple, they include too few asset classes (usually two or three) and round their asset class recommendations to the nearest 10%. This simplification reduces the number of possible asset class combinations, which leads to suboptimal recommendations and lower returns on investments.

http://www.forbes.com/sites/ciocentral/ ... e-bankers/

Is there any validity to this statement? Their website claims that using 7 asset classes rather than 3 will get you an extra 0.5% per year.
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Re: Too few asset classes?

Postby KyleAAA » Mon Jul 01, 2013 11:46 pm

Not really. Simplicity beats financial rigor a lot of the time. 7 asset classes is all well and good, but I don't see how you can say 3 isn't enough.
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Re: Too few asset classes?

Postby freebeer » Mon Jul 01, 2013 11:48 pm

There's a bunch of threads about "slice and dice" vs. "KISS", plus a page on the wiki: http://www.bogleheads.org/wiki/Slice_and_dice. I'm a middle-of-the-roader myself, holding 4 equity classes (TSM, Total International, plus small-cap-value and emerging markets tilts). But of course the Wealthfront guy would have to argue for his more complicated approach ... if you are going to "lump" what's their value add? Backtesting-based claims aligned to an agenda have to be taken with a grain of salt.
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Re: Too few asset classes?

Postby Rodc » Tue Jul 02, 2013 6:45 am

Wealthfront is not a serious outfit. They are a marketing firm. They keep changing their message hoping to get people to buy in. This is just their latest attempt to build a successful business model. Maybe someday if they find something that markets well they will stick with it; for now they keep shopping new marketing campaigns.

That aside, it is an open question as to whether or not slicing and dicing into sub-asset classes is worthwhile or not (note: sub-asset class, not asset class). If it is it must be done in a tax and implementation efficient manner. So for example might be worth doing in tax advantaged accounts if you can do so with no trading costs. Or at least rock bottom costs.

Believing you can make allocations to better than a rough approximation is nonsense. I'd trust someone who said, "Look, no one knows the optimal allocation with any precision, but I do think a solid dose of small value has a reasonable chance of being useful going forward. So let's split your domestic equity into TSM and SCV, say 2/3-1/3. Or if you want to be more aggressive 50/50. But remember SCV is expected to be more risky, so let's bump up bonds by 5%."

I would not trust someone who said, "Putting 8% into SCV is the wrong amount. It should 9.3%."
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Re: Too few asset classes?

Postby Simplegift » Tue Jul 02, 2013 8:07 am

boggler wrote:Is there any validity to this statement? Their website claims that using 7 asset classes rather than 3 will get you an extra 0.5% per year.

Theoretically, adding more less-than-perfectly correlated asset classes (with similar returns) to the portfolio should make it more efficient, with higher returns and less volatility. But in real life, the advantage of going beyond the basic Three Fund Portfolio is an open question.

For an example, see the six portfolios in the chart below, with data over twenty years from 1991-2011. Note that the simple three fund portfolio (Portfolio 3), with just U.S. equity, international equity and U.S. bonds, accomplishes 99% of the total return and 96% of the volatility reduction of the more complicated portfolio with six asset classes (Portfolio 6). Is adding 10% TIPS, 5% commodities and 5% global real estate really worth an additional 0.1% return advantage per year?

Image
Source: Northern Trust

PS. Due to globalization, correlations among alternative risk assets have been increasing and excess returns shrinking, so their advantage to one's portfolio over the next 20 years may be even less. See Bernstein's, Skating Where the Puck Was.
Last edited by Simplegift on Tue Jul 02, 2013 8:19 am, edited 1 time in total.
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Re: Too few asset classes?

Postby staythecourse » Tue Jul 02, 2013 8:12 am

boggler wrote:From an article by the head of Wealthfront:

Online brokerage firms aren’t much better. They offer free asset allocation tools, but those tools prioritize simplicity over financial rigor – in effect interpreting da Vinci’s thought in the most shallow fashion.
To keep their work simple, they include too few asset classes (usually two or three) and round their asset class recommendations to the nearest 10%. This simplification reduces the number of possible asset class combinations, which leads to suboptimal recommendations and lower returns on investments.

http://www.forbes.com/sites/ciocentral/ ... e-bankers/

Is there any validity to this statement? Their website claims that using 7 asset classes rather than 3 will get you an extra 0.5% per year.


I can believe this is true for numerous reasons. One of the top of my head is if you are using multiple asset classes you are likely diverifying into subassets that have a higher expected return, such as: SCV, REITS, EM, international small, high yield bonds on the bond side, etc... This, of course, will likely give a higher return in the long run thus the extra return annualized over time. Did not read the article, but would say that discussing return ONLY is a BIG NO NO. Even with the logic I presented it is in exchange for HIGHER risk.

Other reasons, could be: Rebalancing bonus which is likely greater for the more volatile and lower correlationg assets you add to a portfolio which likely would be greater with 7 assets vs. 3.

Good luck.
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Re: Too few asset classes?

Postby momar » Tue Jul 02, 2013 9:07 am

Why limit yourself to 7 assett classes? Why not 10? 15? 100? Especially when we get to define what an assett class is.

"Small cap emerging market value insurance stocks when combined with large blend Euro tech stocks provide maximum diversification"
"Index funds have a place in your portfolio, but you'll never beat the index with them." - Words of wisdom from a Fidelity rep
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Re: Too few asset classes?

Postby G-Money » Tue Jul 02, 2013 9:16 am

boggler, didn't we talk about this in a thread you started 2 months ago? viewtopic.php?f=10&t=115987
Don't assume I know what I'm talking about.
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Re: Too few asset classes?

Postby Call_Me_Op » Tue Jul 02, 2013 9:34 am

boggler wrote:From an article by the head of Wealthfront:

Online brokerage firms aren’t much better. They offer free asset allocation tools, but those tools prioritize simplicity over financial rigor – in effect interpreting da Vinci’s thought in the most shallow fashion.
To keep their work simple, they include too few asset classes (usually two or three) and round their asset class recommendations to the nearest 10%. This simplification reduces the number of possible asset class combinations, which leads to suboptimal recommendations and lower returns on investments.

http://www.forbes.com/sites/ciocentral/ ... e-bankers/

Is there any validity to this statement? Their website claims that using 7 asset classes rather than 3 will get you an extra 0.5% per year.


Not will get you - is expected to get you. That's a big difference.
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Re: Too few asset classes?

Postby nisiprius » Tue Jul 02, 2013 11:58 am

Theoretically, you should be able to get a better color gamut if you use four different colors of light instead of the traditional three (R, G, B). So, theoretically, you should get an improvement if you buy a display with four different pixel colors instead of just three. You really can't quarrel with the theory, and such displays actually exist: the Sharp Aquos Quattron, for one. And Google finds me some reviews that suggest that reviewers think the improvement is visible.

How many pixels colors does your monitor or TV use?

Do you know anyone who has a four-color model at all?

Anyone?

By the way, the theory involves some diagrams that look pleasingly like efficient frontier charts. In this one, the outer curve is the spectrum of pure wavelengths; the area inside represents all visible colors (all possible mixtures of spectrum colors). The kite-shaped area shows all of the colors that can be produced by mixing R, G, Y, and B light sources. With only three sources instead of four, you would only be able to produce the smaller range of colors in a triangle formed by connecting R, G, and B.

In short, you can improve your color gamut by diversifying your set of light sources.

Yes, I think there's some validity to the analogy, up to and including the question of, even if you grant that there's improvement, is that a lot of improvement or just a little, and is it worth the extra cost and complexity? (Stretching it even further... DFA fans would say that those stinky cheapjack Vanguard funds are impure light sources like the R, G, and B dots on the diagram, while DFA funds are positioned farther out, closer to the true spectral colors).

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Re: Too few asset classes?

Postby afan » Tue Jul 02, 2013 7:08 pm

I don't know why Forbes publishes this nonsense as editorial content. I hope they get paid for what are really extended advertisements. But then they should identify them as such.

A previous "contribution" from Rachleff in the pages of Forbes, from before Wealthfront was pitching indexing, which was before they were selling active asset allocation

John Bogle Didn't Have All The Data

http://www.forbes.com/sites/investor/20 ... -the-data/

Read it, laugh, and resolve not to further waste your time with AR or WF.
"We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either." | | --Larry Swedroe
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