It's Time to Dump Static Asset Allocation

Jahnke, William
June 2004
Journal of Financial Planning;Jun2004, Vol. 17 Issue 6, p26
Academic Journal
The article expresses views on the need for the financial planning community to dump static asset allocation. Denigrating all forms of active asset allocation became broadly accepted in the financial planning community in the 1990s. Active strategic asset allocation solutions based on changing investment opportunities got lumped together with short-term market timing as a failed practice. Static asset allocation is based on the belief that asset class returns are produced by a stable return-generating process: returns from period to period are drawn from a return-generating process that has a stable mean and standard deviation. Such a process will produce successive returns that are independent, identically and normally distributed. These are the assumptions of the random walk model that form the basis for the common practice of extrapolating asset returns and risk premiums. The assumptions of the random walk model are among the most extreme and unrealistic assumptions in all of economics. The random walk model became popular among academics because the standard statistical tool kit requires mean returns and standard deviations that are stable and normally distributed. By the end of the 1980s, the cumulative evidence against the random walk model was sufficient that academics still preaching efficient markets had largely abandoned it. The financial planning community adopted static asset allocation for several reasons. First, financial planners did not understand at the time was that static asset allocation was supported by the random walk model, not the efficient hypothesis. Second, they did not understand that the Brinson studies of pension fund returns' findings were based on an analysis of quarterly variations in returns, not cumulative returns. Third, William Sharpe's capital asset pricing model supported investing in the world wealth index. Finally, Harry Markowitz's mean-variance security selection was for using analyst forecasts of returns.


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